Why Receiving a Tax Refund is BAD

Why Receiving a Tax Refund Is BAD

 

After reading this article I feel you will be smarter than 95% of all Americans because you will realize why receiving a tax refund is BAD. I believe that people completely misunderstand what a tax refund really is and what it means when you get one. To get started, let me offer anyone who reads this a deal. My deal is this:

I want you to lend me whatever amount of money you feel you can lend to me every month for a year. I will do whatever I want with YOUR money for a year and you have no say or control over what I do with it. I could even invest it and earn money on your money. Three or four months later into the following year, I’ll give you your original money back. I won’t pay you any interest or even say ‘thank you’.

Who wants to sign up for that deal? No? Well that in essence is what a tax refund is. You are electing to give the government too much money either through withholding from your paycheck or through estimated tax payments and the result is that they use your money and then give it back to you when you file your taxes.

Here is a case study to drive this point home. Let’s look at a person at a regular 9-5 job and who receives a paycheck. He chooses to fill out his W-4 by claiming zero exemptions because someone told him that he will get more money back from the government when he files his taxes. He goes about his year and saves a tiny bit and gets through the year with $500 in debt. Then he is happy because he gets his $2,000 tax refund. He happily pays off his $500 in debt (which was originally $475, but due to interest is now $500). He takes the remaining $1,500 and buys some things for $1,000 and puts $500 in the bank.

Now let’s say instead that he claims more exemptions on his W-4 and that $2,000 flows into his monthly pay, which is $166.66 per month. He puts $100 of that into his 401(k) plan, which saves him $20 per month in taxes. He invests $50 per month into the stock market and the remainder just goes into his cash flow, so he doesn’t end up incurring any debt throughout the year. So after 12 months, he has $1,200 invested in his 401(k), he has $600 in an investment account, and no debt. That is a much, much better scenario then a tax refund!! Plus, if the money he invested grew throughout the year, then he has even more money!

The two most common types of feedback I get from people when I talk about this are 1) I don’t want to owe money to the IRS and 2) I like the forced savings because it comes out of my paycheck.  In response to the first: I honestly prefer to owe money each and every year on my taxes because that means I got to use my money versus the government! And as long as you pay in taxes what you owed in the prior year, then you won’t be subject to any penalty. You can work with a qualified accountant who can run a tax projection and tell you what to claim in exemptions on your W-4 and you can change that at any time by talking to your Human Resources department. The accountant can also help you by working with you to avoid any penalties. If you don’t want to work with an accountant, then the simplistic way is to just increase your exemptions by 1 per year until you stop getting a refund, but that is inefficient and not suggested. As a quick side note when it comes to exemptions on the W-4: The government has no idea what kinds of deductions you have, so the worksheet they provide is super basic and not typically accurate. Therefore, if you have many deductions then you should claim a higher exemption number.

When it comes to people that say they like the forced savings out of their paychecks. My response is just to increase their 401(k) or to start a monthly deduction from their bank account into an investment account. I am not a fan of having a monthly amount taken from checking and sent to bank savings. The savings can be moved to checking with a few keystrokes on a website or a few swipes on your smart phone. It needs to be somewhere that it is hard to get to. I suggest either increasing the contribution to your company retirement plan right out of your paycheck (which saves taxes and your employer may match) or starting a monthly savings plan right out of your checking account into a separate investment account (like at a mutual fund company or brokerage account). Either way will accomplish the same thing and at least you have the chance for your money to make money versus just letting the government hold it for a year…

I hope you found this topic useful and everyone who read it that currently gets a refund will now go to the HR department, up their exemptions on the W-4, and increase what they save per month! As always, please feel free to email me with topic ideas or contact me for a complimentary consultation.

 

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