Thursday, February 27, 2014

The Psychology of a Tax Return

Psychology Tax Return
Yesterday morning we got our federal tax refund deposited into our checking account. And at almost $700, it felt great. Mrs. Done by Forty and I started talking about some of the fun things we could do with this money: we could put it towards an upcoming vacation, or maybe spruce up the house with a DIY project. But after a while, I had to catch myself and ask: why am I getting excited about our tax return? Isn't it a bit odd? We give the government money that we earned, all year. And then when we get a little of our own money back, it's like we won something: like it's some prize we're lucky to receive. Like Teddy KGB says in Rounders: it's a f-ing joke, anyway. Uncle Sam is paying me with my money.

Teddy KGB thinks tax refunds are a joke.

It's a devilishly clever system the IRS has set up. We give too many tax dollars to the government throughout the year. The next year, we do all the work, for free, to verify the exact amount we should have paid (or we pay someone to do so). And when we get some of our own money back, we thank the heavens. That's a pretty sweet deal for the IRS. I wonder if Uncle Sam is riding the pony and making the Teddy KGB O-face every time he mails back a portion of our money.

As you can tell, I'm not a huge fan of paying income taxes. While I think local taxes are a fantastic deal, and we get a lot for our money, it's not the same with federal taxes. I am very appreciative of the military protection our tax dollars provide. And I like that programs like Medicare exist for our elderly citizens. But for the most part, I don't feel like the basket of services we get from the federal government is a particularly good deal. Compared to what we get from our local government, federal government seems pretty expensive.

Where Did the Income Tax Come From?
If you've never heard the surprising history of the US federal income tax, this Planet Money podcast is a fascinating and easy way to do so. Did you know that the IRS employed Donald Duck to pitch the idea to the American Public? True story. And it stuck, too. Now, just about all Americans pay their income taxes, every year. Never let anyone tell you the government is incompetent: they convinced an entire nation to start paying taxes on every dollar of their income, and they did it using a cartoon duck in war propaganda. Try convincing your neighbor to give you $15,000 sometime by sending him Family Guy clips. Here's the 1943 propaganda film (which gets pretty dark around the 4:19 mark):


Acknowledging the obvious good that our taxes did in the fight against the Axis, getting a refund does still feel a lot better than owing. A 2012 survey found that many people view a large refund as a means of forced savings, akin to a mortgage. Additionally, Ramit Sethi points to research indicating that people will save lump sums in times of hardship, while small amounts paid regularly (like, in your paycheck) will probably just get spent. Jason Hull wrote an excellent post outlining that same point: we are more likely to save a refund. So maybe a tax refund is a win-win for bad savers and the US government: the American public gets a forced savings program that sets them up for success, and Uncle Sam, well, he gets to hold onto our money all year.

But the readers of this blog are good savers. (Aren't you?) We'd be better off getting one or two thousand dollars throughout the year, and using it to invest, to help buy income properties, or to pay down high interest debt. Right? Or would we really be happier, and maybe even better off financially, if we got a lump sum the following year? Let me know what you think.


*Photo is from Steven Depolo at Flickr Creative Commons.

60 comments:

  1. I think it's ridiculous that we need to spend the time figuring out how much in taxes we overpaid when the government knows full well how we we each owe them. And if you don't do your taxes, they keep your money instead of saying, "oh you overpaid us, and by our own good will, we will give you the difference back." Each year at tax time, I get all upset over this issue. I'm not the brightest crayon in the box, but I want to figure out how much in taxes I should owe each year, make sure I pay it, then when I hit that mark (let's say 8 months in to the year), claim exempt on my pay checks going forward so I can keep as much money as I can without overpaying the government at the same time. I'm a good saver and could definitely use that extra cash throughout the year for investing.

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    1. Mathematically, you would come out ahead if you invested that money throughout the year, for sure. It's always interesting to me when research points to the counter-intuitive answer though.

      I also think it's a pretty crappy double standard with taxes and overpaying. If you owe too much, the government charges you interest and a penalty. But if you pay too much throughout the year, do you get interest back? Of course not. :(

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  2. I'm not a huge fan of income taxes. Of course, is anyone? But I do agree that the services, while some are vital, are not as great as we get from our municipality. I would much rather have small portions throughout the year, and be able to save or invest, or even spend as I see fit. But, I suppose most people aren't that good with their money, and this is another way for Uncle Sam to say that they know best. Really though, most people I know spend their refund on some useless crap rather than paying down debts or doing something smart with it. It's a shame.

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    1. Hey there, Ryan. I have to admit that I'm one of those people who is bad with the tax refund, as every year I want to spend it. Today, literally right after writing this post, I went up to my wife and said that I wanted us to get iPhones. She said I was crazy, since our Androids are fine. And she reminded me that last year, I tried to use our refund to buy a THIRD scooter.

      I am bad with the refund...

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  3. I actually adjust my W-4 throughout the year. My refund was under $300. That's about what I aim for. I don't mind Tue taxes, but I wish it was easier to get the right amount taken off throughout the year! I sent all of mine to the mortgage the second it appeared in my account.

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    1. Hi, Leigh. I try to adjust my W-4 throughout the year, too, but I'm bad at estimating the extra income/deductions from other sources (like the room we rent).

      Great system you have there with applying your funds to the mortgage! Your net worth updates are so inspiring -- you are killing it!

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    2. leightpf - Love that you send the refund to your mortgage. So simple, but brilliant. I worry that most buy flat-screen tvs or other impulse buys with their "forced saving".

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  4. I am not a fan of taxes. I claimed 0 exemptions for 2013. I also paid an extra $3K in federal taxes in addition to the 0 exemption. I still have to pay another $8K or so. Those are some of the taxes I have on my ‘passive’ income stream.

    Last year, in 2012, I got a refund. So my passive income stream is really taken off. Financially, it’s best to have to pay just a little bit, but a refund sure is nice. With interest rates being low, it doesn’t matter too much. If rates get to 5%+, it will matter a bunch.

    I feel fortunate to have made the money to have to pay the tax, but I probably pay more in taxes than some the goals some people that are aspiring for FI.

    I plan on adding more about my financial journey as time allows, but I have been focused on some general landlord topics for now.

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    1. Good point about interest rates: things will start to matter more if you can get a risk free 5% return on your money.

      I also like your perspective on paying taxes. It's a good problem to have, I suppose, as it indicates you're making (more) money.

      I'll have to stop by and check out more of your blog, too. Thanks for commenting!

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  5. With the exception of the year we sold our rental property (and got a whopping 25k back), I have no idea what it's like to get a federal refund. We have our W4s set to take out the max (0 exemptions) yet we itemize deductions and *still* owe. Luckily, it's never enough for penalties, but we have to plan for owing every year, it's just a matter of exactly how much. I've been slowly reducing what we pay to the state though, we always get a refund from them, and I'd rather owe a little or get just a little back.

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    1. You can actually set your W-4s to take out an additional amount of income tax. If you always owe, I would consider doing that.

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    2. @Three is Plenty : do you end up having to pay quarterly estimates, or a penalty for owing? I've never thought that was entirely fair but I guess it's just another instance of the feds being pretty clever with the income tax system.

      As leigh noted, using that one slot to have additional funds withdrawn is a way to get an accurate amount withdrawn.

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  6. I hate saying it, but the psychological impact of making a large payment on my student loans, and seeing the balance drop so dramatically, kind of makes me enjoy receiving a lump sum back. It's just not as exciting to send in smaller payments on a weekly basis. It wasn't until I started reading PF articles about tax returns last year, that I truly realized we're giving the government an interest-free loan. After my debt is paid off, I'll probably work on optimizing my income tax.

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    1. Hey EM! It might end up being a pretty savvy move, if a counter-intuitive one. Jason Hull is one of the brightest minds out there in the PF world, and he's in favor of getting the big refund.

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  7. After I do my taxes each year I do a back-of-the napkin calculation of what I expect our taxable income to be the following year, then also use the IRS withholding calculator to adjust my withholding. I always aim to owe less than $1000, but as close as possible -- which is one of the safe harbors for avoiding penalties and having to make estimated payments the following year. I use TurboTax to do my taxes, and it helps me a lot with year-to-year comparisons. This year I'll owe the Feds $962, but get back $200 from the state. I call that a pretty good year.

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    1. Nice! That's incredibly close to your goal, Christy. And yes, owing less than $1000 is the magic number.

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  8. My wife and I paid in last year for the first time ($1,500 was the damage). This year, mainly due to my side hustles, I will pay in a significant amount. I haven't calculated it yet but I'm sure it will be an ugly number. At the same time I almost prefer to pay in now because I don't like the good feeling I get when I get a tax return. It's such a psychological thing, as you pointed out, because rarely do we stop and think "oh, I gave the government this money to hold onto. I really am not "gaining" anything at all."

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    1. I'm glad that your side hustles are doing so well, David! I'll have to email you sometime to pick your brain on that. I'm lazy when it comes to side hustling.

      I like your take on owing, too. For you, it's the right approach, for sure, as you'd be less happy with the refund.

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  9. Yep, income taxes suck, especially when the voters don't get a voice in where the taxes are spent, that is the biggest problem. Bet if you took a poll and gave every tax payer 5 options of where they want their tax dollars to be spent, the lion share would be to pay down the debt. This just epitomizes the disconnect we have with our friends in Washington!

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    1. I had a feeling you and I would see see eye to eye on paying income taxes, Jim. ;)

      I believe the voters do get a voice: the Tea Party movement was an illustration of that, when voters illustrated how important reigning in spending was. Now, I don't agree with their politics, but I love seeing when voters organize around issues they really care about, and put representatives who align with those issues into office.

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  10. It is funny to think about people getting excited about a return as if it was free money from the government. I mean you actually earned it, so what would you do with any income? :)

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    1. That's a good point, Tonya. We don't view our income tax refund as income...it's a strange disconnect.

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  11. A few years ago my Dad casually mentioned I shouldn't be getting a refund from the government and instead be owing them. At first I thought he was crazy but as I dove head first into the world of personal finance and investing I see he's right. I hate this mentality of taxes being a forced savings account. How about you just learn to handle your money and teach yourself to save instead of hoping Uncle Sam will give you a decent return? I feel quite Ron Swanson when it comes to taxation...but alas I still must pay them.

    P.S. Thanks for letting me know about that Planet Money podcast! Just downloaded it for my subway ride to work tomorrow. I started listening to Planet Money about 4 months ago, so I love hearing about great older episodes.

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    1. I'm glad you're a Planet Money podcast listener, too! It's a great show.

      And anytime you can be Swansonesque, I figure you're doing something right.

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    2. Ron Swanson is THE best.

      It's incredible how hard it is to save a little at a time, but its such a great habit to get into. I rely heavily on automated withdrawals to make sure it happens.

      I was shocked recently by a AAA Fair Credit proposal. They were looking to partner with one of the online savings groups to help get people out of poverty. The concept is CRAZY, but popular. Example: You are a member of a group of 10 people and you each save $105 per month over 10 months. Each month, one of the members get the pool of $1000. You essentially PAY $5 per month to be forced to save. The social contract is what you are buying. Everyone has to follow-through on contributing to make it work.

      Apparently this type of savings circle is deeply rooted in multiple cultures, including Latino and Pacific Islanders. Of course the informal circle that convenes during the lunch break at work doesn't come with fees, but also no interest.

      We try not to pay anything during the year toward our federal taxes and simply save up several thousand for what we will owe. It will only work until we become more profitable and then have to pay the estimated pre-payments in advance (totally unconstitutional).

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    3. Yeah! Another Ron Swanson fan!

      I've heard of those savings circles, and they seem remarkably effective. Never underestimate the power of social pressure. If I miss my personal, private savings goal for one month, it's no big deal. If I miss it on the month my coworker was going to pay for her vacation...then I have a problem.

      So as it is, Emily, do you end up not having to pay throughout the year, and just true up early in the following year? That sounds like a fantastic system for the time being.

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  12. Alas, I CHOOSE to overpay ($50 per week) so that I don't have a debt, as I'd hate to have a whopper bill at tax time. Seeing our tax time is during (your) northern hemisphere's summer, I often use the return to pay for a holiday to the US or Europe. Sure, I could go down to the line and not over pay, but to be honest, I'm not sure I'd get the same gains from it (as in I might possibly fritter away that $50) - I could!?

    Alas, I also don't bemoan taxes, as I've lived in a tax free country and it relied on aid to fix pot holes (and no one likes pot holes - hospitals, sure, schools, yep, pot holes "boring"!

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    1. Sheesh: I guess that's the downside of not paying taxes. Going without basic services, like road repair. I might complain about taxes, but they do cover the things that the community needs but aren't particularly profitable.

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  13. We have a different system here in the UK. You file your accounts (only if you have to fill in a tax return), after the year is done and then pay what you owe.
    My husband has his personal tax (on salary) adjusted throughout the year when any changes occur. So he would only have overpaid if he hadn't kept the tax office informed of any changes.
    I'm not a tax expert, and I'm hoping I'm right with this! Perhaps your other UK readers will weigh in.
    I do agree with paying a certain amount of taxes but of course feel they're too high!

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    1. That sounds like a cool system, Laura. Do you end up paying in arrears (e.g. - in 2014, you pay throughout the year for the amount owed in 2013?)

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    2. Yes! If you're only taxed through salary then they take it at source over the year. If you're self employed then you have until a certain date to pay it.

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    3. Oh, that sounds lovely. Paying in arrears is the very best option.

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  14. Well... I've gotta say that once you enter the realm of the self-employed, doing taxes becomes a whole other ball of wax. It's not that it's particularly difficult, it's just tedious and there's absolutely no hiding from the fact that you're being forced to part with your hard earned money. There are no automatic deductions - you have to pay four times a year and then make up the difference at tax time. And you also don't have an employer to pick up half of the tab for social security & FICA - which all comes off before any deductions... so that's a big hefty OUCH even if you don't make enough to have to pay federal income taxes. And even if you've somehow managed to overpay, there's just no reason to get a refund since you're just gonna have to turn around and pay more in a few months - so it generally just gets applied to next year's taxes.

    Anyhow, my days of looking forward to tax returns are long, LONG gone!

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    1. The part about taxes gets left out of posts on the benefits of being self-employed, doesn't it? The extra SSI and Medicare taxes alone make it pretty rough.

      At least you're not giving the government a loan though, right?

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    2. True... but I think that it's something that people entering self-employment need to be aware of, and to think about, especially when they're first starting out. I started my business while I was still employed, and it was small enough so that the withholdings from my real job were sufficient to cover any taxes that I owed.

      But then I quit my job and expanded the business significantly. I did great, and made more money than I'd ever made before... but imagine my shock when I did my taxes that first year and got slammed with a $20,000 tax bill! Fortunately, I had socked most of the money away, frugal soul that I am, so I had the cash on hand to cover the bill. But I suddenly started to understand how it is that self employed people can get themselves into real trouble with the IRS if they're not careful.

      It got better after that because you have to make quarterly payments that equal at least the total amount that you owed in the previous year - so at least the pain was spread out a bit, but those first few years were a real shocker for me, and if I had been the kind of person who spent every dime that came in the door, I would have been in a serious world of hurt.

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    3. Whoa! $20k in one year. I guess that's a pretty good problem to have, as it means you are making some good coin. Still, I don't know how happy you can be sending in a check for $20k.

      I'd love to read more about the business you're in, EcoCatLady. I'll admit that I haven't read through the archives of your blog. Do you share the story of your self-employment there?

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    4. Well... I made some money - but not the amount you might think. My adjusted gross income that year was around $55K - I actually made closer to $75K and socked away as much as I legally could in retirement stuff, but while retirement contributions are tax deferred for the sake of federal income taxes, they're not for Medicare/SSI (self-employment taxes). Apparently my brain rounded up the figure because the actual tax bill was more like $18.5K ($10K of which was self-employment tax). Anyhow - being self-employed is great, but you do take a wallop on taxes.

      At any rate, my business is basically maintaining a handful of websites - most of them are graphic design stuff - I give away free pictures, backgrounds, greeting cards etc, and I make all of my money from ads on the sites. The first few years were a real bonanza even though I really only had one site back then - but it was all tied in with the MySpace crazy so it did really well while that crazy lasted. I don't make anything close to that kind of money now, but I decided that the time was more valuable to me than the money.

      Anyhow, if you want to read more about it, here's a link to a post I wrote about it:
      http://ecocatlady.blogspot.com/2012/12/how-my-cat-helped-me-achieve-financial.html

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    5. That was supposed to say "MySpace craze" not "MySpace crazy" - though it was that too!

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  15. I get it that people love getting a big refund. They tend to think of it as free money. But like you, I hate paying taxes to a government that I believe is mostly wasteful (military not included). Hubby (a former IRS agent!) and I calculate what we expect to owe and then structure our withholding and estimated payments so we will come as close to zero balance due or refund as possible. I simply hate giving the government an interest free loan of my money for a whole year. I'd much rather divert that money into our investments. So as long as we avoid the underpayment penalty, we are cool with owing a little, or at least not getting a refund.

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    1. Must be nice to have a former IRS agent in the family to help with the taxes! As you're a saver, I can see how getting the money throughout the year should be better off.

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  16. That cartoon is indoctrination at its "best", isn't it! I totally agree that it's better to not get a refund, but for people like us, on super tight budgets, it forces us to do better at not spending. Plus, for me, it's psychologically better to get a refund than to have to write the IRS a check. That drives me crazy. :-)

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    1. Yeah, that cartoon is a trip, Laurie! There's an ancillary benefit from getting a tax return that I hadn't thought of: it forces you to live on less all year.

      Tax returns are a way to be more frugal, long term...hmmm, wish I'd thought of that bit before writing a post!

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  17. I actually love the idea of slamming a huge amount of money to my debt (or savings depending on the situation) but at the same time - I really do hate it when I think about the fact that the government has been sitting on my money for the better part of a year.

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    1. It's a bit of a catch-22, isn't it, Alicia? When I hear about behavioral economic stuff, like how we're better off saving money in lump sums after the fact rather than throughout the year, I wonder if it equally applies to personal finance nerds...

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  18. I used to be one that got a big refund back in the day, and this year I received $7. While I should be pleased since that's the way it should be, I was admittedly a little disappointed about not getting a 'bonus' back (even if that bonus was really my own money). It's something to get used to!

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    1. I hear you, Anna. Despite my best efforts I always end up with a refund. Our income is a bit variable, and my limited understanding of the tax code isn't a big help...

      In the end though, I sure do like getting a refund. Like you: I'm used to getting that 'bonus'. I wonder if the opportunity costs are small enough to justify, so I can just keep getting them?

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  19. So true! Logically speaking I know that getting a big refund is not a good idea. It just means that I gave the government an interest free loan, but psychologically it feels nice to get a nice refund. My co-workers claim 0 so they can get a big fat check at tax time. Apparently they like loaning interest free money to the government.

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    1. I have the same dilemma, Andrew. I think I'm leaning towards just getting a small refund. If we're talking even $1,000, it's not as though it would make me that much in the markets over one year.

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  20. The US tax system might have worked in 1943, but it is frankly shameful that in the 21st century it is still structured this way. Similar to your UK poster, I started my adult taxpaying life in Denmark where they automatically calculate exactly the amount of tax you owe and deduct it from your paycheck. At the end of the year, you get a list of what you paid and the deductions you qualified for which you can review and adjust if needed (there something like <1% of people need to). Coming back to the states where I have to do all the work of figuring my tax liability and filling out forms, etc. was a rude awakening.

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    1. I'm envious of the simplicity of that tax system, Reepekg. Did you find that your taxes in Europe were much higher than they are in the US? Even if they were, where would you say you get the most value for your taxes: US or Europe?

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  21. I try to think of the money I get from my tax return the same way as I do any source of income, delegating some to savings, some to expenses, and some to play.

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    1. That's really the best way to do it, Stefanie. It's all income...treat it the same.

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  22. My wife and I try to set our tax withholding so that we owe a little bit come April. I would rather the government loan us money throughout the year than the other way around. Of course, you have to make sure you pay enough to avoid paying a 10% penalty at tax time.

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    1. That's the rub, Bryce. I'm always a worried that I'll mis-estimate some form of taxable income, end up owing a bit too much, and then paying a penalty.

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  23. Not to get too pedantic, but the income tax got in with the 16th Amendment. The withholding clause was what was introduced in 1943 with the Current Tax Payment Act. Either way, it sucks ass.
    (yes, I don't like paying taxes either)

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    1. You're absolutely right, 101 Centavos. Proving once again that the information on this blog really should not be taken without a grain of salt, or trusted, or probably even read. :)

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  24. What you say is completely logical but I still enjoy getting a large refund. But it probably would be better to get that money throughout the year and invest it earlier.

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    1. Great name for a site, Thomas! I like getting a refund too. I may not be as sub-optimal as we think.

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  25. Tax refund = a loan you gave the govt. at 0% interest.

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    1. That's true! But I've seen some evidence that people will save at a higher rate with that 0% loan.

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