Fallacy of a Fat Tax Refund
Many people think of a large tax return as “found money,” or money that is forgotten because it isn’t seen in a pay check. Others use it to save for a “big ticket” purchase. However, from a financial perspective, it means that you paid more than you had to. A large refund is also a lost opportunity to invest money. Often, tax professionals boast about getting people large returns, but I believe the best value for you is paying as little as possible. I believe the goal of a tax professional should be reducing your overall tax liability, not getting you a large refund.
Is that how the tax thing works?
I’ve had people sitting across my desk from me, asking this question. It can be difficult to explain why one wouldn’t want a large tax refund. It is important to know that income is taxed differently than wealth. The ultimate goal should be to reduce your tax liability to the point where you pay as little as possible and get no refund. If you pay less in taxes, you can enjoy yourr money throughout the year or use it to build your savings.
Can a large refund be harmful?
Has your tax preparer ever talked to you about an IRA? This is a beneficial was to reduce taxable income. It is referred to as tax planning. Some people may not be aware may that if they are a W-2 employee, they can request their withholding be adjusted by a specific dollar amount. You can request that this amount be deducted from your check and placed in a n IRA. If you are withholding at a higher rate than necessary, making this change will not lower your gross income, and you will be building savings rather than helping the IRS.
The average tax refund in 2016 was $2,945, so approximately $250 per month was being held by the IRS with no future benefit for the taxpayer. where that taxpayer received no return and no future retirement benefits. This money is better invested in that account that will grow, tax-free, for your future.
There’s even the potential to earn free money
Many employer-sponsored retirement plans offer a matching contribution up to 50%. So, if you contribute $10,000, your employer will contribute $5,000. The tax code encourages investing for the future by offering these tax incentives, but it is estimated that fewer than 50% of people who have the opportunity to invest in employer-sponsored retirement plans actually do so. Don’t be one of those people who misses this opportunity!
Behavioral economists use the term “mental accounting” to refer to the people who use large tax refunds as “found money.” But consider this: If the average taxpayer took the $2,500 average refund and invested each year it in an employer-matching retirement fund, a 6% net return over 40 years would result in a $600,000 retirement fund! Now ask yourself, which would you rather have?
Tax Refund or College Planning?
Have you wondered how you’re going to pay for the high cost of college for your child or grandchild? Rather than receiving a large refund, you can invest in one of the many tax-advantaged savings tools, such as a special fund used for qualified education programs. These funds are similar to an IRA in that it is tax-free growth and there is no tax liability if used for qualified education programs.
Rainy Day Funds
Do you have a rainy-day fund? Are you saving for the future? If not, that extra money that is being withheld from your paycheck can be better used to help build one. A Roth IRA offers tax deferral on any earnings deposited into the account. Withdrawals from this account can be considered tax-free if they meet certain restrictions. However, withdrawals before the age of 59 may result in a 10% tax penalty.
Tax laws are always changing and have the potential to impact tax-free retirement funds. It is a good idea to consult a tax professional before investing in or making withdrawals from such accounts.
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Stephen Wallick started Stephen Wallick & Associates to provide tax and accounting services to Contractors, Real Estate Investors, and Realtors. Steve specializes in IRS Tax Resolution services and works with his clients to resolve cases under scrutiny by the IRS. As a tax professional and enrolled agent, Steve can save you money with IRS loopholes each year. With over 20 years going up against “The Man”, Steve is uniquely qualified to resolve even the toughest IRS cases.