Although one firm advertises, “Get Your Billions Back America”, getting a tax refund can actually be harmful to your financial health. Did your tax preparer ask you if you had participated in a company-sponsored retirement plan? Further did they mention reducing your taxes by taking out a traditional IRA? If so, did you have the cash to do it? Did you get a refund?
The fallacy of the benefit of a fat tax refund
You may hope to hear that you’re going to get a tax refund. From your emotional, some might say behavioral side, hearing that you’re going to get a refund sounds like found money. It may even conjure up ideas on how you could use the money now. However from a financial perspective a refund represents a lost opportunity cost for things you could’ve done in the past. Also, It means that you paid more than necessary. Often tax professionals sell their value on helping you get a tax refund. I believe the value you want is paying as little as is legally necessary. I believe their value should actually be reducing your overall tax bill and not getting a refund. Do you actually know how much you paid in taxes?
It’s possible that through tax planning you may decrease your tax burden to the point where you pay less in taxes and get no refund. If you were looking for a refund you may be disappointed. However, you paid less in taxes and enjoyed the money throughout the year. I’ve had that conversation with some people who did not understand how the tax thing works.
The harm of the tax refund
Did your tax preparer suggest that you take out an IRA to further reduce your income? Some people find that they are getting a refund, but don’t have the cash to pay for an IRA. When they get the refund they have other things in mind for using the money. They may be unaware that if they are a W-2 employee that they can go to their employer and change their withholding by a specific dollar amount. Let’s say that amount is $225. You can then set up an automatic withdrawal from your checking account into an IRA. This would reduce the prior tax year’s refund to close to zero. This is referred to as tax planning. Rather than simply prepare your taxes as the majority of people do, this is a proactive approach to looking at the tax code in order to best leverage its opportunities to reduce your income tax.
Turning a $2500 tax refund into $615,000
The average tax refund in 2014 was $2696.1 In fact over the last four years tax refunds have totaled $11,000. 2 That means that roughly $225 per month was sitting in an account where that average taxpayer received no return and no future retirement benefits. The refunds roughly equate to half the available amount to invest in a traditional or Roth IRA. Money is invested in that account could be invested and grow tax-free.
There’s even a potential multiplier. It’s estimated that fewer than 50% of the people who have the opportunity to save an employer sponsored retirement plan do so. Many of those plants provide a matching contribution. Up 1.5 percent from the average refund of $2,656 in 2013, according to a new report on how well the Internal Revenue Service operated last tax season. One of those things is to have saved to enhance your retirement. In fact, the tax policy wants you to do that. That’s why it offers you tax incentives, like advantage retirement savings.
If that $11,068 could’ve been matched by the employer by 50% that average taxpayer would now have a balance of $16,600. Those lost funds would’ve cost them nothing. Behavioral economists would weigh in and say that these refunds often have a special place in the taxpayers mind. They call this mental accounting. That’s where dollars like a refund are considered plus money and could be used for things like a new TV or vacation or some other item that has a more present benefit. However what would happen if that person took the $2500 plus the matching contribution and invested it getting a 6% net return over a 40 year period? They would have $615,000 to help pay for their retirement lifestyle.
This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.
Tax refunds and College planning
Have you wondered how you’re going to pay for the high cost of college for your child or grandchild? If you’re the parent, one of the ways to use your tax refund is to invest it in one of the many tax-advantaged savings tools. Many of these work like a Roth IRA tax-free growth and no taxes if used for qualified education programs. This $225 to provide a nice systematic way for you to save on ongoing basis. This should allow you to enjoy the benefits of a dollar cost averaging approach to investing. You can also take advantage of a systematic approach to saving for your grandchild as well in one of these college savings plans.
Dollar cost averaging involves continuous investment in securities regardless of fluctuation in price levels of such securities. An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.
Cash reserves and next steps with your refund
Do you have a rainy day aka cash reserve? The $225 per month can help build one up. Earlier I highlighted that over the last four years tax refunds totaled $11,000.
I find that many people need help with the details and to overcome our inertia to just let things be. I believe looking for a CERTIFIED FINANCIAL PLANNER™ professional is one of the key action steps. CERTIFIED FINANCIAL PLANNER™ professionals are educated in tax planning, financial foundation planning and retirement planning. Often the road to increasing your financial health requires the multi-disciplinary approach a CFP® pro is trained to take. We can help you with the implementation steps such as setting up the systematic withdrawal and changing your withholding. Why not contact us now before your busy life puts this on the back burner?
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
1 Tax Refund Size Increased This Year, WASHINGTON. D.C. (OCTOBER 22, 2014), Accounting Today, http://www.accountingtoday.com/news/irswatch/taxrefundsizeincreasedthisyear723931.html
2 IRS Filing Season Statistics, http://www.irs.gov/uac/2012-Filing-Season-Sta