Just Say No To A Tax Refund
Do you get a tax refund from the government every year? If so, why? You’re loaning them money, at no interest. Banks usually don’t loan you money at no interest, so why would you do it for the government?
For the sake of math, let’s just say you get $3000 back from Uncle Sam this year which is what the IRS claims is the average refund. That’s $3k extra that you allowed the government to borrow from you by taking it out of your paychecks last year. It’s your money. They then give you back the $3k in April or whenever you get your refund. They give you back only the $3k, nothing more. It was your money to begin with.
Now, if you didn’t allow them to do that by upping your exemptions on your W4, you could have been investing that $3k all last year. In case you’ve been under a rock, the market went up 21.17% last year. Uh.. yeah.
So what did you lose? Well, you could say $3000 * .2117 = $635.10. But that’s not accurate because that assumes you had that $3k starting last January 1st and invested it all year long. The truth is the money would have accumulated paycheck by paycheck into your account during the year as the market went up and
The calculations are too complicated in this hypothetical, but it’s safe to say you lost a lot of money! Not quite $635 But probably at least $200 – $300.
And oh yeah, that whole year while Uncle Sam took an interest free loan from you, inflation happened. So that $3000 that belongs to you – not only do you receive no interest, it’s actually worth less now in 2018 because inflation eroded some of it.
Inflation in 2017 was 1.6%. So now your $3000 is worth $2952.00.
Now, let’s say you do this every year for 30 years. What would your $300 of unrealized annual market gains accumulate to? Assuming a 7% annual market return…
I realize the market won’t give returns every year like it did in 2017 so $300 might not be the most realistic number to use, but you get the picture. Compounding interest is your friend, and when you let Uncle Sam take free loans, you’re losing out.
I Don’t Get It
I’ve heard many people justify getting a tax refund by saying “it forces me to save”.
What they’re really saying is that they know their personality and that they’re probably incapable of saving money when they get it. So the only way to save is to not have the money come to them in the first place – to have Uncle Sam take too much out of their paycheck and give it back next year.
If this is you, what happens when you get that refund? Do you spend it anyway? What’s the point in playing this “forced savings” game with Uncle Sam if you’re gonna spend it anyway when you get it back? (with no interest)
If you do stash your refund away in a mutual fund or investment, then kudos. If that’s what it takes for you to save money, I’m not here to judge you. But remember that it’s not optimal, and you’re missing out on earnings.
And here’s the thing, if you want to set up a “forced savings” scenario because you’re incapable of saving money once you see it, then have automatic deductions go to your Vanguard account every check. It’s the same principle. But instead of the deductions going to Uncle Sam with no reward, you’re paying yourself.
Ok Sometimes I Get It
Some of you out there have very complicated tax situations, and being able to adjust your W4 appropriately to plan on not getting a refund is extremely difficult if not impossible. I get that.
You might have alimony, multiple rental houses, complicated business deductions, farm benefits, or overseas investments. Our tax code is so painfully complicated you can give the same scenario to 5 tax “experts” and get 5 different results. And sadly the new tax law did nothing to simplify it.
So if you have one of these complicated scenarios every year and you get a refund then you might just have to live with the reality that interest free loans to the government are part of your existence.
The best advice in this scenario would be to at least try to minimize how much that interest free loan is. If you err on the side of loaning Uncle Sam nothing, you might wind up having to pay extra when you file the following year. I’ve been doing that for over 20 years, and I just prepare for it by having money set aside.
In this case, I’m taking a loan from Uncle Sam, keeping it invested (ie, making money on it) and then paying him back with no interest.
So should you underpay like I do?
Turn The Tables
Note of caution here – if you do underpay you have to be careful to not go overboard! Yes, you can be penalized for underpaying too much. When do underpayment penalties kick in?
From the IRS website: “Generally, most taxpayers will avoid this penalty if they either owe less than $1,000 in tax after subtracting their withholding and refundable credits, or if they paid withholding and estimated tax of at least 90% of the tax for the current year or 100% of the tax shown on the return for the prior year, whichever is smaller. “
I’ve owed over $1000 in some years, but never paid the penalty because I’ve always paid well over 90% of what I owed, and usually 100% of my previous year.
What’s the sweet spot? Well as you can see playing a game with Uncle Sam and taking too much of an interest free loan can backfire. So depending on your income and how much you pay overall, my advice would be to shoot for underpaying by about $500 – $700 per year – only if you have a simple tax scenario and can calculate it accurately with deductions on your W4.
Of course you have to prepare to pay the remaining taxes the following year. If you keep that extra money invested in your VTSAX or even a decent savings account at a credit union, you’ll make extra on it. It’s basically leveraged investing.
I do the latter since cashing shares out of a mutual fund requires you to pay capital gains tax. Granted, the interest I get isn’t all that great these days, but my credit union is way better than the paltry rates at regular banks.
Chime in financial warriors – do you give Uncle Sam an interest free loan or take one from him?