Monday, April 15, 2013

Risk Aversion

What is the average interest rate these days?  According to one source it is puny:
Throughout the entire industry, however, the national average bank interest rate for savings accounts is only .21 percent

So why might be it rational to overpay your taxes by a small amount?  Consider this comment from Megan McArdle:
A tax refund is not free money you get from the government. It’s free money you gave to the government—by overpaying your taxes all year. You think the interest rate on your savings account is paltry? At least it's not zero, which is the amount Uncle Sam pays you for your yearlong interest free loan. (If you underpay the government, on the other hand, they charge you not only interest, but also penalties.)

On one hand her advice is completely sensible.  It makes a lot of sense to reduce a very large tax refund.  On the other hand, you need to save a lot of money for the 0.21% interest in that savings account to outweigh the interest and penalties.  Since even interest is 3% (15 times the savings rate), I think it makes sense to aim for a small refund rather than to make errors on both sides of the distribution (since underpaying is much more expensive than the lost revenue from overpaying).  This logic may not hold if interest rates and/or inflation pick up in the future. 


  1. Joseph:

    Good point, especially for those of us whose income fluctuates somewhat unexpectedly from year to year.

    More generally, it's not rational to try to micro-optimize all aspects of life. I once met someone who's obsessed with frequent flyer miles. Sure, it's cool to get the occasional free flight, but there's a cost to finding all these bargains, also a cost to flying a day you don't want to fly or changing planes or whatever you have to do in order to get the miles you want.

    Considering all the mistakes people make with their money (notoriously, paying continuous credit card balances at high interest rates), I can't see that paying some of your taxes early is such a problem. Sure, it's not optimal behavior, but McArdle is stretching things a bit to call it "an enormous mistake."

  2. A much larger mistake, that I only made once (in Canada) is to underpay your taxes and then not have enough money in the bank to pay the balance owed. That was a fabulously expensive error.