Tax refunds and time value of money
Can you make decisions that change how much taxes you owe each year?
Few things strike terror into the hearts of most Americans more than tax season. Whether it is the ever-looming threat of an audit, the hours spent staring at paperwork, or paying an expert only to learn that you owe money, it is generally an unpleasant time for most. Surely, you have heard the phrase “nothing is certain in life but death and taxes.” This month I’d like to convince you that tax season is an opportunity for you, and not something just to dread. Many people go through the motions each spring, but they miss small opportunities throughout the year to pay less in taxes when the bill comes due. Central to this issue is a simple question. Would you rather give the IRS a tax-free loan to hold your money all year, or would you rather have that money yourself? Second is, are your taxes set in stone each year? In other words, are there decisions that you can make that change your situation? Or is tax filing just an accounting exercise that is solved before you even start? I’d like to argue the former; there are many decisions you can make that drastically change your tax situation. Many people have the perception that their tax bill each year is chiseled into stone and an unchangeable result of their financial situation. In this article I want to show you one simple way that making a small adjustment in your tax decisions can lead to long-term savings.
Is a large tax refund a good thing?
Do you get a big juicy tax refund each spring? Do you look forward to that refund and plan major purchasing decisions around its arrival? What if I told you if you are getting a large refund check that you are making a poor financial planning decision? A big refund check is exactly that—a refund of your own money back to you. If you haven’t been receiving that money in your paychecks throughout the year, that means you’ve been giving the U.S. Government a tax-free loan. My guess is that you probably don’t want to give the government a tax-free loan, so why do so many people fall into this trap? The answer is that many folks use IRS tax withholding as “forced saving” device. That is, they don’t have the willpower to save themselves, so they allow the government to use their money and “save” it for them, so they can receive as a lump sum the following year. Tax withholding is simply the portion of money your employer sets aside from your paychecks to cover your taxes. If you withhold too much, you loan the government your money and you will get a tax refund. If you withhold too little, the IRS sends you a bill.
Time Value of Money and your taxes
From a personal finance standpoint, the best option for your refund status is to get as close to “$0” as possible. Why? Because of a concept called “time value of money” or TVM for short. TVM means that your dollar today is worth more than a dollar in the future. This is because money can earn you interest throughout the year, either in investments like stocks and bonds or even in a high-yield savings account. In addition, inflation continually makes each dollar worth less as time goes on (about 2% less per year normally, but much more in the current economic environment). According to IRS filing statistics, the average tax refund for the 2019 tax season was $2,725. If you get paid twice a month and receive the average refund, you should have had an extra $105 in every paycheck. Consider if you took that $2,725 and invested it throughout the year in the stock market. With a modest return of about 6%, contributing monthly, you would have about $2,800 by end of the year. This doesn’t include inflation, which will make the difference even more dramatic. Obviously, this is not a lot of money for the average person, though it can be serious money for higher earners. But one of the benefits of following good personal finance habits is that many small differences throughout the year can add up to large differences over time. Regardless of the dollar amount, it will always be better to get access to your own money right away and become disciplined enough to invest and save wisely, as opposed to letting the government hold that money for you.