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I guess I am doing my taxes wrong? I am receiving around 1000 dollars in tax refund, and someone tells me it should be as close as to zero as possible, I thought the tax refund was government giving back most of the taxes that have been taken out of our paycheck? I guess I have been doing it wrong to maximize my refund? I only made ~9000 last year.

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A lot of people just think they get a refund after taxes and that's just how it is. This is wrong - you only get a refund if you paid more in taxes throughout the year than you were legally responsible for. Yes, many people do overpay, which is why they get a refund. If you paid the right amount, you'd get no refund (which is good actually), and if you paid too little, you get a bill. A refund isn't guaranteed nor automatic. One shouldn't plan what to do with their refund - rather one should plan how not to get a refund next year. – SnakeDoc Feb 15 at 20:30
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@SnakeDoc I think that perspective is somewhat silly. Or at least, there are certainly people who like getting a substantial refund each year. And unless we're talking about very large amounts, points about interest/the time-value of money are more pedantic than practical. Even if you could get a guaranteed 5% interest rate on your cash (good luck with the current fiscal settings), you're talking about an extra ~$50 on a $1000 refund (and that's only if the government has the full amount, for a full year). – aroth Feb 16 at 5:24
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@aroth - I don't see where SnakeDoc ever mentioned interest. The point is that you gave your money to the government when you didn't need to. Think about it for a second, If I were to go to you and say please give me $1000 aroth and I promise I will pay you your $1000 back next April. If you were very confident that I would really pay you back, do you think that's a good idea? If not, why? If you answer the why then you know exactly why getting a big refund is not good for most people. However, if you have no discipline to save, then it is a good way to force no-interest savings on yourself. – Dunk Feb 16 at 14:06
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@Dunk Getting a bit less every month and in return getting a larger sum once per year is actually a reasonably attractive proposition to some for purely psychological reasons (it's obviously not a rational choice). Basically I don't really notice having $100 more or less in my paycheck every month, but a $1200 "surprise" is fun! – Voo Feb 16 at 18:35
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@Snake Yes very rational, now if only humans were actually rational actors (the most ridiculous assumption that economists just love to make). Don't construe this as sensible investment advice, just as an attempt at explaining observed behavior. – Voo Feb 16 at 19:07

11 Answers 11

You don't "need" your refund to be as small as possible, but you usually would want it to be as small as possible.

The reason people say you should aim for a small refund is that getting a big refund means you paid more in taxes than you had to. This means you gave away money that you could have done something else with. You get the money back later as a tax refund, but you lost the ability to use it during the time the government had it.

For instance, if as you say you are getting a $1000 tax refund, that's $1000 that you are giving to the government over the course of the year. At the end of the year, you get it back, so you end the year with $1000. If you instead kept the money, (by paying only exactly as much tax as you owe throughout the year) you could invest it somehow, so that by the end of the year it could potentially have grown to, say, $1050. Thus at the end of the year you would have $1050 instead of $1000.

Ideally you would have zero refund and owe zero extra at the end of the year. However, since it is often difficult to make things work out so exactly, people often say you should aim for a small refund.

Assuming you are in the USA, if your income is only $9000 you will likely not owe any federal income tax at all, so you could claim exemption from withholding and avoid paying any tax ahead of time. You could check this when you file your taxes by seeing if the refund you get is equal to the total of taxes withheld from your paychecks over the course of last year.

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In some places, the interest that the government pays on overpaid income tax is so large that it is a quite attractive form of saving. It was like that for me when I was living in Sweden. – gerrit Feb 15 at 10:35
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So, to put it short: You just gave your government a loan. Usually it's zero-interest loan. – Agent_L Feb 15 at 12:01
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@Agent_L Plus it plays right into the hands of their inflationary economy - effectively, you get less back, even ignoring the opportunity cost. – Luaan Feb 15 at 14:39
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@MartínFixman Only if your investment returns significantly exceed the IRS underpayment penalty, at which point you should have just gotten a loan and invested on margin anyway if you think that's a good idea. – Zach Lipton Feb 15 at 17:44
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@gerrit - Also in Canada. The Canada Revenue Agency currently pays 3% interest on overpayments, which beats the hell out of savings accounts or government bonds. – Compro01 Feb 16 at 3:35

Years ago, a coworker bragged to me how his "tax guy" got him a huge refund. I told him my goal was to owe a couple thousand dollars, and that I'm glad I didn't have his guy.

In the end, your return should reflect the truth, and a good tax guy will be little better than good tax software. The bottom line is that a refund is money you lend the government, interest free. If you can owe a bit of money but avoid paying a penalty, you'll have gotten a free loan from Uncle Sam.

Given the fact that most (it seems that way, someone tell me if I'm wrong) families carry some balance on their credit cards, they are paying out 12% or more on their highest interest debt. Lending the government even $1000 for the year comes at a cost, if you file in time to get your refund by the end of March, that's an average 9 months you are out your money. 12%/yr is $90. Scale that up to $3000, the average refund, and the max 24% rate I've seen, $540 lost. Better to adjust your withholding, and get the extra money each paycheck to pay off other debt.

Obviously, for those with no debt, their cost is minimal, perhaps 1%, but still better in your pocket for the year.

If you pay in this money every paycheck, only to feel good getting it back every March or April, while paying 18% card interest every month, that's your choice. And Stevej will support that decision, or so it seems.

EDIT - The Huffpost article Steve linked titled "Big Tax Refunds Really Are Good" ignores this debt, only focusing on the near zero rate banks offer now. The article listed 8 reasons the author felt this way. By the way, the author is the "Chief Tax Officer, Jackson Hewitt Tax Service Inc" which makes him a bit less than a disinterested third party. And all 8 of his reasons are far from compelling. "In my opinion, getting a $3,000 check is never a bad thing." This was #1, and by now you know why I disagree. Next, "More than 75 percent of all individual taxpayers get refunds year after year. It has been this way for decades.... It is unlikely that 75 percent of all taxpayers are all making bad financial decisions every year." That's enough. Rhetorical nonsense. Read the rest for yourself and decide if the next 6 reasons are any more compelling. Keep in mind, sellers of tax software or services have backed themselves into a corner with the "largest refund" claims. I'm sympathetic to the fact that "we'll shoot for no refund at all, in fact, our goal is for you to owe just $100" will not be their next campaign.

EDIT 2 - I gave this more thought as I started to write a near 1000 word post on this topic. I came to find that 1 in 4 employees did not deposit enough in their 401(k) to capture the full match. This is the highest lost opportunity as the potential return is an instant 100% for matched deposits. Again, it's easy to dismiss the near zero bank rates, but that's not the alternative best use for the money.

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Maybe if your coworker had engaged "his guy" from the start of the tax year, instead of only to file his return, then he'd be where you are. He's basically bragging that he hired a guy to haul a huge truckload of garbage out of his front yard. Yes, that's great, but people who don't dump their garbage in their front yard don't need to do it. So pay a guy to tell you (or figure out for yourself) a better way to deal with garbage. – Steve Jessop Feb 15 at 20:52
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Worse yet, that $1000 refund is more often than not blown away on extravagant purchases (it is found money, after all!) instead of being used to pay down that credit-card debt. – Dilip Sarwate Feb 15 at 23:23
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If you take out the part of the credit card debt I have to agree with the JH CTO. You aren't getting any return on your money in a bank these days. So really it is more like a yearly savings fund. Will people splurge part of their tax refund. Maybe but I think they would be far less likely to spend it this way opposed to coming in monthly. When doing budgets you wouldn't account for this. If you set it to equal zero your balance sheet will be close to 0 at end of year. Here you are gaining money which in most cases goes to unexpected things or savings. – blankip Feb 17 at 23:13
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@Joel I have no documentary evidence but plenty of anecdotal evidence from friends, family, etc as well as with people that I meet through a money management advice program that I am involved with (I am an advisor). Tax refunds have never been used to pay down credit card debt but always spent on something else. YMMV. – Dilip Sarwate Feb 18 at 3:49
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@DilipSarwate - I get a couple thousand back in taxes every year. I max out my 401k, I have some money in stocks and zero cc debt... The money I get in taxes I would never invest so it is either have it sitting in the bank earning almost nothing or the refund. I don't think my buying habits would change much if the money was their monthly or not but my wife definitely likes to see a certain amount in savings and the low point of our savings every year does coincide with xmas... so we save more. We never buy something based on our return, it just replenishes savings. – blankip Feb 18 at 5:50

I would go even further: You should want to pay as much as possible with your return without having to pay a penalty. This lets you keep your money as long as possible without costing you anything extra. You don't want to overdo it and pay fees, so leave yourself some buffer. Still, try to get yourself in the mindset that paying at tax-time is a good thing!

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The sad fact is, owning money at tax time is a major stress and financial burden that many people can't handle. While what you say is true, the chance of someone actually saving enough money to pay their taxes at tax time and having invested that money to make a small profit is very, very small. – JPhi1618 Feb 15 at 15:02
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Some people are built for playing as close to the edge of the rules as possible without breaking them: they thrive as NFL defensive backs and treat the occasional call for pass interference and fine for helmet-to-helmet as all part of the job. Other people like to know they're nowhere near the edge, so a slight overpayment on taxes helps them sleep all year round since they won't have to rectify underpayment by any fixed deadline. That said, the questioner is in effect getting late payment of $1000 out of their $9000 annual earnings, which seems way too much to pay for peace of mind. – Steve Jessop Feb 15 at 20:43
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This "owe as much tax as possible" tactic could also leave you open to very large penalties should something go wrong when it comes time to pay - unexpected expenses, job loss or anything really, problems filing, late, etc – Xen2050 Feb 16 at 8:55
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I'm really shocked and saddened by the number of comments on this thread from people who either cannot manage their money or believe that others cannot do so. In addition, it seems like people have a very pessimistic view of what these penalties are. The penalty is some interest that's less than, say, the amount that you're probably already paying on your credit card bill. I never suggested pushing it all the way to the edge and leaving yourself stuck - All I said was that paying is better, which is inarguably true. Whether or not you can practically achieve that is something different. – Brick Feb 16 at 14:10
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Optimal strategy is to owe money at the end of the year, but not enough to pay any penalty. No two ways about it. Anything else represents suboptimal financial planning or discipline. The OP didn't ask what's easiest...just what is best – farnsy Feb 16 at 22:56

Let's say you should have paid $4000 in taxes in a year, but you paid $5000, so you get a tax return of $1000. "Somebody" thinks that you should have tried to only pay $4000 in the year and get zero tax return. I hope he or she doesn't think you should pay $5000 and mess up your tax return so you get no refund.

Once the end of the tax year is there, you should do what you can to get as much tax returned as possible. On the other hand, you should also have tried to pay less during the year - obviously every dollar you paid less is a dollar less refund.

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Well, on my W4 I didn't count myself as independent.. so, only 10% of taxes is taken out of my check. Instead of 20% (if I count myself as independent) – andyADD Feb 15 at 16:16
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$9000 is below the standard deduction and exemption. You should have zero tax due for the whole year. No need to withhold even $1. – JoeTaxpayer Feb 15 at 16:22

The pure numbers answer says you want the refund to be close to $0. You can even argue, as some answers have, that you want to try to maximize the payment without receiving any sanctions for underpaying during the year.

If you trace the money, it's easy to see why. Let's say you get a paycheck. Tag some of the dollars for Uncle Sam. These are the dollars that, eventually, will be given to the IRS. Now consider the following scenarios:

  • You keep all of the money in your own accounts, leveraging that money. Perhaps your bank has a $2000 minimum deposit before incuring fees. You used to have to keep $2k of your money in the bank, doing nothing. Now, instead, you can put $2k of Uncle Sam's money in the bank, gaining utility from it. Then, near tax time, you make sure you have $2k of your own money in the bank, pay Uncle Sam.
  • You withold all of the money tagged for Uncle Sam. You no longer get any benefit from that money. However, at tax time, Uncle Sam already has all the money he's going to ask for in his coffers.
  • You withold even more money. Now, not only do you not benefit from that money, but in fact you're loosing access to money that wasn't tagged for Uncle Sam, but you gave it to him anyway! Then, at tax time, he hands you back the parts that weren't tagged. That money could have been providing leverage, such as investment or keeping banking fees away, but it didn't do so because you gave it to Uncle Sam, interest free, instead.

From the raw numbers like this, its clear that you lose utility by setting yourself up for a large refund check. The money was yours the entire time, but you chose to give it to Uncle Sam instead.

However, the raw numbers are only part of the puzzle. If you're a cold steely-gazed numbers person, they're the part that matters. When the billionares are playing their tax evasion games, this is the only thing they are paying attention to. However, real humans have a few psychological reasons they may choose to lose utility in terms of raw dollars in exchange for psychological assistance:

  • Many have a hard time "earmarking" money. If the money is in the account, they use it. It's not ideal, but its how real people behave. In this case, they are using the IRS as a poor quality savings account. It's horrible fiscally, but they may be able to psychologically write it off as "its not my money," and then see a boon later.
  • Some are not very good at saving for big things. I know many individuals choose to use the IRS piggy-bank as a way to save for large things that need to be done.
  • Some view the emotional trauma of being in debt to the IRS to be a sufficiently brutal scenario that they would rather be confident that they're covered rather than taking the time to run the numbers and arrive at the logical answer.

These attitudes exist, and may be ideal for any one person. Obviously the financially savvy answer of "minimize your refund" is the ideal answer from a dollars and cents perspective, but its up to you to see whether that attitude is right when you account for all of the non-measurable things, like stress. In general, I would lead anyone to "minimize your refund," but I would be remiss if I didn't include the very real psychological reasons people choose to deviate from it.

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You had me at utility, but the use of that word implies a level of education the average person doesn't have. Can we agree on this "Understand your own cost of money, whether it be your highest rate debt, likely an 18%+ credit card, or the best return you can get investing, whichever is higher". – JoeTaxpayer Feb 17 at 12:20
    
@JoeTaxpayer I think we can agree, lumping the intangible costs in with "cost of money." I like to pay extra attention to those, because we often forget about them when given an opportunity to crunch old numbers instead =) – Cort Ammon Feb 17 at 15:28
    
True folks. We are discussing opportunity cost, and utility, and even PV/FV concepts. The fact is we should know how much tax we are paying and how much we should be paying. We could go further and talk about payday loans and class struggle - what it costs the poor to be $10 short, say. The major issue issue I have with using my income tax contributions as a de facto sinking fund is that I might need the money and not be able to access it. I am not poor, but I am asset rich with a pretty thin cash flow, every dollar helps. I can't even borrow against it. – mckenzm Feb 18 at 6:21

It depends on when you're setting the goal.

1) When you have finished the year and you are filling out tax forms, your goal is to get as large of a refund as possible.

2) When the year begins afresh and you are earning money and paying taxes, your goal should be roughly to pay exactly the amount of tax owed so that at the end of the year you don't have any refund or tax owed - it's the same as getting your tax refund right away rather than waiting until after you file taxes. So you want your W4 set up appropriately (assuming you're talking about the US).

I think (1) is obvious. For (2), imagine you start the year with the goal to get the largest possible tax refund at the end. Well that's simple - fill out the W4 and on line 6 ("Additional amount, if any, you want withheld from each paycheck") tell them to withhold everything. Then at the end of the year you'll get a huge refund. Of course in the meantime, you've made an interest-free loan to the government, and you've probably had to take out a high-interest rate loan from your bank or credit card. Obviously this is bad.


An argument could be made that it would be even better to slightly underpay your taxes (but not enough to owe a penalty). Ignoring human weakness, this is correct. If you have the discipline to set that money aside in a safe place, that's okay. If this would cause you to spend that money (or even save less of your other money), then this is a bad idea.

So I'd really want to highlight some of this depends on your own financial discipline - is it better for you to have the money right away so that you can make good choices with how to use it now, or is it better for you to put the money somewhere out of reach so that you won't spend it on impulse purchases? (and recognize that there are ways to put it out of reach and earn interest on it rather than spending it - one good choice for you would be a Roth IRA)

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Your question begins with a misunderstanding.

When you prepare your tax return (Form 1040/1040A/1040EZ) you always try to minimize your total tax bill.

When you fill out form W4 you trying to estimate how much tax will be shown on next years tax return.

The penalty for having too much tax withheld is not having the use of the money until you get a tax refund. At the moment interest rates are very low and your economic loss is the temporary loss of access to the money. One exception would be if you are carrying credit card debt. In that case you are, in effect, paying 20-30% interest to borrow money you lending to the US Treasury for 0% interest.

The penalty for having too little tax withheld is having to make a large payment with your tax return. If your pre-payments aren't at least as much as your total income tax from last year there may also be modest underpayment penalty based on the difference between your pre-payments and your total income tax from last year or this year whichever is less. A large underpayment will trigger a different larger underpayemnt penalty.

The W4 combined with the withholding rates tends to over-withhold income tax for most, but not all, taxpayers. Most people don't have enough savings to pay a large tax due, which leads to more penalties and an even larger bill. Over-witholding protects the overall tax system from the consequences of those events. People tend to be very unhappy, not quietly.

On balance your greatest economic benefit depends on whether or not you have high interest debt. If you do, then accurate and even slightly under-withholding will probably work to your advantage as long as you can pay next 4/15. If not, avoiding the chance of having any unexpected balance due next year may be more important.

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Underpayment penalty is a percentage of the shortfall of your withholding plus (timely) estimated payments from 90% of this year's tax or 100% (110% for higher income, 66% for farmers and fishermen) of last year's tax. Since it's a percentage this goes up with the amount of underpayment, but I've never seen a 'different' penalty on larger underpayment. Although if your withholding was low because you claimed undeserved exemptions on W-4, there is a separate fixed penalty for that. – dave_thompson_085 Feb 22 at 23:12

Something I've not heard mentioned in any of the answers is that (at least for me) owing some tax money is better than having a refund from a ID theft/fraud/security aspect.

The US IRS has been hacked several times recently and there have been cases of fraudulent tax refunds being filed and tax refund checks being cashed by ID thieves. Well, if you owe a bit of tax then you're less of a target for fraudulent tax refunds being filed in your name.

Even in the case that you were unlucky enough to have had your identity stolen, at least you don't have to deal with the IRS trying to sort a mess like that up.

Thus, (IMO) it's better to owe a bit of tax, than to have a small refund, or any refund for that matter. Ideally, you want to get to zero dollars owed like you suggested, but that's often pretty hard to do. So, the next best thing is to owe a bit.

One should try to calculate tax liability quartely or if income changes, adjust your withholding, so that you get closer to zero tax.

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The people committing the fraud are using your id info to file taxes, the numbers they use for income and deductions are fake. The idea i to get money before the IRS computers catch the discrepancy. They don't care what your income was, or how much you had withheld. – mhoran_psprep Feb 21 at 13:24
    
@mhoran_psprep There's two parts here: the risk thieves pick your identity for fraud isn't affected by your legitimate balance or even tax, but IF they do pick you then the hassle of resolving it is worse in the refund case. – dave_thompson_085 Feb 22 at 23:16

Having a large state return also means that there is a potential income tax liability created at the federal level for the following year, as the situation resulted from the deduction of more on one's federal return than should have been deducted. The state refund is treated as federal income in the year it is refunded.

http://blog.turbotax.intuit.com/tax-tips/is-my-state-tax-refund-taxable-and-why-90/

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Set aside any perceived positive aspects of being owed a refund and weigh those with the negatives. What are the reasons you should not have your money tied up with the IRS? You'll see that Uncle Sam does not have a good track record as a financial institution:

  1. Has a history of delayed repayment.

Many thousands of refunds every year are delayed for many months due to IRS systems glitches. Yet, many people count on that refund which is not always guaranteed within the stated time-frame.

  1. Is above the law

You have no legal recourse. You cannot sue the federal government for the money you lent them when they decide not to pay you back for an extended period of time. Yet, if you decide to delay paying them, they have all the power and will use it to charge you fee's that no corporate / private institution would get away with.

  1. Has a history of fraud see SteveJ's answer above.

"owing some tax money is better than having a refund from a ID theft/fraud/security aspect"

  1. Will not pay you interest

Again, there is zero financial incentive to lend free money to Uncle Sam, he is not a bank. The only time interest comes into play is when the refund is overdue. Even then, it is not an incentive / doesn't come close to the penalty burden on you if you don't pay your taxes on time.

I would ask the followup question: What sane person would engage in business with such a financial institution?

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I contend that there is great value in over-paying during the year and reaping a bigger refund.

I'm an engineer and understand the concept interest earned, blah blah. But for most of us, this isn't reality. The reality is that we spend what we earn, plus a little more.

At the end of each month, if the typical American has money left over - we spend it. We don't faithfully put that money that we would have payed into taxes to good use (such as savings or paying off that credit card).

Getting that big refund at the end of the year tends encourage us to make that one-time large payment to that high interest account, or to purchase that item that we otherwise wouldn't have saved for (or purchased with a credit card).

I say, give Uncle Sam the free interest - you'll have wasted that money during the year anyway - and enjoy a nice healthy refund that you can put to use for something you enjoy.

Life is just too short.

[Edit] For the nose snubbers that can't think beyond the possibility of a different perspective: Link1 Huff Post

SteveJ

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The government isn't a bank account. Put your money into a bank account, or, if you're the type that lacks self control, an account that you can't touch (CD or something). It'll grow faster, and you can get access to it (depending on the account type you chose) if an emergency comes up. And, not everyone has money left over a the end of the month, sometimes even resorting to credit cards. Having extra money may be more beneficial right now, instead of a year from now in one large lump (which is likely to be blown on some toy). – SnakeDoc Feb 16 at 19:01
    
How many of those people that lack self control create a CD do you think? We are talking about real people here. Changing your allotments is something that we all have to do anyway and only takes a second. I'm not saying your wrong theoretically, it just isn't the way most people behave. BTW. I'm debt free except for mortgage. – SteveJ Feb 16 at 19:07
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Steve, it's not about the few cents interest. It's the fact that while lending the government this money, they are still in debt on their credit cards. You have no high interest debt, and despite an engineering degree which implies an embrace of logic over emotion, still wish to use tax withholding as a Christmas club account? No issue. The average tax refund is $3000, money better used to pay $250/mo toward that debt that others have. – JoeTaxpayer Feb 16 at 19:11
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@SteveJ As I believe JoeTaxpayer mentioned in another post in this thread - the effective interest rate will vary from person-to-person. If you have credit card debt, instead of paying that down quicker, you're costing yourself a lot more than $15 per year in most cases. – SnakeDoc Feb 16 at 19:54
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@SteveJ Just to poke a hole in that argument - if these people had an extra, say $100-$400 available every month, they'd have the opportunity to save as they wouldn't be stretched so thin financially. Do what you want personally, but it's not really the smartest thing to do or rely on. – SnakeDoc Feb 16 at 20:09

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