Getting a tax refund is exciting — who doesn’t love extra cash? But that check from the government can actually be harmful to your financial health. In fact, a refund is often a sign that something is amiss in your financial plan.
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. However from a financial perspective, a refund means you paid the IRS more than necessary. So instead of thinking about how you’ll spend your refund, think about what you could have done with extra cash in hand all year.
Often tax professionals sell their value on helping you get a tax refund. But that shouldn’t be what you’re looking for. The goal isn’t a refund, but to pay as little as you legally have to. So a tax professional’s value should actually be reducing your overall tax bill and not getting a refund. Ask yourself: Do you know how much you actually paid in taxes?
It’s possible that through tax planning you may decrease your tax burden, pay less in taxes all year, and get no refund. If you were looking for a refund you may be disappointed. However, if you paid less overall, that’s a win for your financial plan. This is a conversation I have to have each year, as many clients look forward to that tax refund.
Turning a $2500 tax refund into $615,000
The average tax refund tends to be around $2,500 (a number that varies each year but hovers around this amount.) Using that number, you’d be paying roughly $225 extra each month to Uncle Sam. Put another way, it’s like sending the money to an account where you receive no return and no future retirement benefits. Think about what would happen if you invested that in an IRA where it could grow tax-free.
There’s even a potential multiplier. It’s estimated that fewer than 50 percent of the people who have the opportunity to save in an employer-sponsored retirement plan do so. Many of those plans provide a matching contribution. If that $2,500 were matched by the employer by 50% you’d have $3,750 more money in your employer-sponsored plan in a given tax year. And that’s just in principal.
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” that 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 $2,500 plus the matching contribution and invested it getting a 6 percent 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.)
Repurposing your refund
Some people find that they are getting a refund, but don’t have the cash to pay for an IRA. Meanwhile, putting money in an IRA can reduce your overall tax burden. So if you do get a refund, think about investing that money into an IRA to reduce your taxable income going forward.
Or, if you’re a W-2 employee, you can go to your employer and change your withholding by a specific dollar amount. (This is done via a Form W-4.) If you adjust your withholding by $225, consider setting up an automatic transfer each month form your checking account into an IRA in the amount of $225. This would reduce the prior tax year’s refund to close to zero and 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.
Or, if you’re a parent (or grandparent), one of the ways to use your tax refund is to invest it to help pay for college using a tax-advantaged savings tool like a 529 plan. Many of these work like a Roth IRA tax-free growth and no taxes if used for qualified education programs. This $225 could be a nice, systematic way for you to save on ongoing basis.
Finally, consider whether you have a rainy day aka cash reserve. The $225 per month can help build up an emergency fund. If you did this over four years, your emergency fund would total $10,000.
Tax planning can be tricky, and taking the first steps can feel complicated, which is where we can come in to help. Envision Wealth offers tax planning services that look not just at our tax rate but at your financial situation as a whole. This allows us to create a tax plan that looks to improve your financial situation overall.