Tax Refunds Are Bad!
In case you didn’t know it, it’s tax season and it’s time to claim your tax refund. File early so you can get your refund back and use it to buy a new color TV. I have seen advertisements in the past calling this time of year, Refund Season. Blah, blah, blah!! Stop! I think tax refunds are bad and should be avoided. Here are a couple of ideas that might help.
What is a Tax Refund?
A tax refund is a reimbursement of an excess amount paid to either the federal or state government. A lot of people look at their tax refund as some kind of bonus, when in fact, all you have done is make the government an interest free loan. Maybe it wouldn’t be so bad if it were reciprocal but if you owe the government because of underpayment, you are charged penalties and interest. As a person with my own business, I have to make quarterly estimated payments and if the government doesn’t get their money every 3 months, they charge penalty and interest for that as well.
So what we have here is an unfair game. I give you too much money and at the end of the game you simply give me my money back. I don’t give you enough money and at the end of the game I owe you the money plus penalty plus interest.
During the 2020 tax filing season there were 168.7 million tax returns filed. Of those, 125.3 million received a tax refund totaling 317.7 billion dollars. For dramatic effect that is $317,700,000,000.00! That’s a lot of interest free loaning going on in the United States. 74% of the tax returns filed gave out a no penalty, interest free loan to the government.
Is There a Better Way?
Well, of course there is. First get it out of your head that you’re getting some kind of bonus. All they’re doing is giving you your own money back without paying to use it. That’s just wrong. The second thing I hear is people saying, they don’t want to owe taxes. That’s fine, but don’t give them too much.
How can you fix this problem? Probably the easiest thing to do is ask your accountant how much you should withhold from each check. For most people who receive a salary and have taxes withheld, they claim a certain number of deductions on their W4. Ask your accountant how many you should claim so you get a close to a zero refund as possible.
Another idea is to see how much you actually owed in the previous year. Then go to your human resource or payroll department and have them hold out the proper amount from each paycheck. Let’s say, last year you paid $25,000 in taxes and you get paid every two weeks. In that case you would divide $25,000 by 26 and get $961.54. Tell the payroll person you want $961.54 withheld from each check so you end up owing 0.
What should you do if you’re like me and have to make quarterly estimates? There are two different types of tax rates. Marginal tax rates and effective tax rates. The effective tax rate is the actual amount of money you pay in taxes divided by your income. The marginal tax rate is the tax rate imposed on your last dollar of income.
In our previous example of someone owing $25,000 in federal taxes, their income might be close to $175,000 which would put them in the in the first part of the 24% marginal tax bracket for married, filing jointly. Their effective tax rate is closer to 14%. Here is how I use my YNAB budgeting program to help save for our quarterly estimates.
I look at what I actually paid in both federal and state taxes in the previous year then divide that by my adjusted gross income. That is how I figure out my effective tax rate. Then, every time I get paid, I multiply that amount by my effective tax rate and put that into my budgeting category for taxes. That way, when it’s time to pay the quarterly estimates, I have put the money aside and can send Uncle Sam his money and avoid the penalties and interest for underpayment.
People often talk about what “tax bracket” they are in, but they are talking about the marginal tax bracket. It’s not the amount they are actually paying in taxes. Maybe that could be a reason that 74% of taxpayers receive a tax refund. I’m not sure.
Bad Loan Terms
One of my connections on LinkedIn posted this question. Would you put your money in a savings account that paid you 0% interest and only allowed you to access your money once a year? Of course not, but that’s what 125.3 million taxpayers did with 317.7 Billion with a B dollars. Don’t be one of those people. Figure out what you owe and pay only that. If you want to buy a new T.V., put a new T.V. category in your budget and add to the category every month.
Here are a couple of other ideas. Take the money that you were getting in a tax return and add it to your retirement plan each pay period. According to the IRS, the average tax refund is pretty close to $3000.00. If you take $250.00 per month and invest it for 20 years at 7% rate of return, you would have $130,991.35.
Or take the $250.00 per month and put it in the kid’s 529 plan. You could also use the $250.00 to build up your emergency fund. It’s not the 3-6 months of living expenses that you are “supposed” to have but it will cover a lot of the annoying broken dishwasher or I need new tires emergencies that 40% of Americans can’t cover without using their credit card.
Last one, I promise. With the pandemic and all of its attendant issues, people have started to think about their life insurance. Why not take some of that tax refund and use it to purchase the proper amount of life insurance? Most people are woefully underinsured and this could be a way to bump up your coverage without too much pain.
I’m Not a Fan
In case you couldn’t tell, I’m not a big fan of tax refunds. If you want to talk about some of these things, feel free to reach out to me. I love to talk about this stuff. As always, thanks for reading. KB