Now that income tax season has ended most people feel they can wait till next year to concern themselves with it again. However, by engaging in tax planning now, you will be able to realize benefits in the future. Most people receive tax refunds, however, I will demonstrate that refunds are something that should be avoided, and not to be strived for.
When someone is receiving a refund one is just getting their money back; it is not as if the government is providing a gift. It is the same concept like paying your landlord or mortgage company $1,800 per month instead of the $1,500 you owe, and then receive a refund of $3,600 early the next year. I doubt few people would want to give their landlord an interest free loan, but in recent years 75 to 80% of taxpayers give free use of their money to the government, when they receive a refund.
The average refund is fairly significant, just over $3,000 for someone’s federal return. California has one of the highest state income taxes in the country, which generally total at least one third of federal taxes, so a typical state refund would be an additional $1,000. If that money would be placed in a savings account, in the current low interest rate environment, there would be little benefit. However, most people have loans, or could invest the money at higher expected returns.
Some examples might help to illustrate the potential savings. If someone has a balance on their credit card at a 10% interest rate, reducing the balance by $4,000 over the course of a year would save $400 in interest. Likewise if it was an auto or home equity loan at 5% the savings would still be $200 per year. If someone did not have any debt to be paid off, the money could be invested. A balanced portfolio of stocks and bonds should return about 6% per year on average, so having the extra $4,000 to invest would save $240 per year. Over a decade, whether it be a savings on loans, or potential profits from investments, the added benefits should be in the thousands of dollars.
If someone has been getting refunds on a consistent basis for a number of years, they should adjust their withholding or estimated tax payments. For someone who received a large refund one year due to significant credits and deductions, withholding should only be decreased if those deductions were to remain in place. A clever person may think the best way to maximize cash flow would be to owe the government a large amount at tax time. However, the IRS clearly wants their money sooner, and will levy penalties if you owe too much money. To avoid a penalty someone must have had withheld at least 90% of their tax liability for the current year, or their tax liability from the prior year. For those with incomes over $150,000 the prior year amount is 110%. As a general rule you would not want to receive a refund, but likewise only owe a minor amount, so as not to owe an interest penalty.
Many people like refunds because they consider it a form of forced savings. Oftentimes this refund is used to pay down debt, or fund an IRA. The better approach would be to start achieving those goals now through reduced withholding , rather than waiting till next year for the refund. Use the extra money in your paycheck, as a form of savings either to pay down debt, or increase your 401K or IRA contribution. That way you can improve your cash flow and realize significant savings.