Paul Rose Jr., Wealth of Geeks
Every year, the IRS gives more than $350 billion back to taxpayers who have overpaid.
While the news media and pop culture tends to focus on how depressing the annual tax day is, nearly 87% of Americans get a refund. That continues to happen in spite of the federal government’s efforts to minimize overpayment.
Last year, nearly 238 million people shared an estimated 512 billion dollars, or an average of about $2100 per person.
That’s a nice chunk of change to get back, perfect for investing in a new TV, or if you’re more responsible, paying down your existing debt. But make no mistake — this isn’t free money. In fact, getting an annual tax refund could be costing you money.
For the people who don’t have enough tax withheld from their income, April 15th is not a happy day. On top of what they owe the IRS, if they can’t pay right away, there are fees and penalties added to the tax debt. The federal government also charges interest on that debt, and the longer it takes to pay it back, the more that interest compounds.
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Interest free loan
However, when you overpay on your taxes, you get your money back. The government pays no fines or penalties — it was your fault, after all — but they also don’t pay you any interest. You’re essentially giving the United States government an interest-free loan for nearly 16 months.
Caleb Vering is an associate wealth advisor with Farnam Financial. He recommends a savings-oriented approach. “The Government doesn’t offer interest while you wait for a tax refund. Consider reducing your excess withholding and directing those funds to your 401k or IRA.
“You can potentially receive tax deductions and get your money working for you. If you’re saving for retirement, consider stock index fund ETFs. If you’re saving for a specific purchase such as a car or home, consider high quality short-term bonds which currently offer attractive rates around 5.5% per year.”
He adds, “Risk-free Treasury Bills will always pay better than withholding extra from your taxes. Treasury bills today can offer a 5% annual return and the interest is exempt from state taxes.”
Consider, if you took that same $40 a week ($2100/52 weeks) that you’re overpaying in taxes and put it into a savings account earning just 2% interest, at the end of the year, you’d have approximately $2800 and change at the end of the year.
Maybe an extra $700 doesn’t make that big a difference for you. But drop that same $40 a week into a mutual fund or an ETF earning five to seven percent, and that jumps up to nearly $1100 more — and if you leave it untouched and just keep adding $40 a week, after 30 years, you’ve accrued between 140 and 210 thousand dollars. All from $40 you likely never missed.
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The debt factor
As stated earlier, some folks do use their tax refund to pay down debt. This is an excellent use of the funds. Reducing debt is almost always to your advantage, and paying down a couple thousand on a credit card will save on future interest charges.
There’s only one problem with that scenario. How much interest have you already paid, while waiting for the IRS to give you back the money you earned and handed over to them?
The calculations are going to be different for each person, depending on their credit score and the interest rate charged by their credit cards. Sit down for a moment and calculate how much less interest you could have paid on your credit card by making an additional $40 a week payment.
Even if you stuck to the minimum payment each month, the $40 a week is chopping years off your payoff date. Sooner rather than later, you’ve got extra money to put against your mortgage or into college or retirement savings. If you haven’t already, you should also prioritize an emergency fund.
Financial Dignity Coach Christine Luken points out, “If you don’t have 6 months of emergency savings, or you have high-interest credit card debt — or both! — getting a large IRS refund is costing you money. Why? If you have an unexpected expense, like a car repair or major medical bill, and don’t have an emergency fund, you’ll have to charge it at 15% or more.”
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Refund vs ROI
Moving against the tide and ignoring the popular perception of a tax refund in the spring can be challenging, but it’s definitely worth it. The first step is shifting your mindset. The pain of not getting a “bonus check” should be weighed against the benefits of holding on to your money now.
Jorey Bernstein, of Bernstein Investment Consultants, in Newport, CA, points out, “A tax refund is not a bonus; it’s a delayed wage. Shifting this mindset is crucial. You earned that money, and it’s better off with you, building your financial stability, than sitting with Uncle Sam. Consider adjusting your withholdings to keep more of your paycheck every month.”
For financial experts, holding on to your money and using it to benefit you is key to regaining your financial freedom.
Air Force Veteran Mike Hunsberger, ChFC, CFP, CCFC started Next Mission Financial to support military and former military families and retirees with values-based financial planning. He explains that he tries to convince his clients that they’re losing money.
“I try to emphasize that it’s their money and as long as they don’t under withhold they’ll be fine. I do advise them to save some of that money in case they would owe a small amount to the IRS. The IRS has a calculator that you can use to figure out how much you should be withholding, at https://www.irs.gov/individu als/tax-withholding-estimator.”
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Make it easy
The next step, according to Luken, is to set up a system that makes it easier for you to save. If you’ve been overpaying, you’re not used to having the extra $25 or $50 a month. So use that to your advantage, “…for your first bigger paycheck, take the difference and set up automatic transfers to your savings account or as extra payments on your credit card debt. Automatic transfers ensure that you don’t ‘accidentally’ spend the money instead.”
As Ron Popeil was fond of saying, you want to “set it and forget it!” Arranging for an automated withdrawal on payday to an emergency savings account or credit card payment makes it easy to take advantage of the “ extra money “ and the power of compound interest.
Finally, do an annual review. If you’ve gotten a raise, you’ll want to make sure you’re still withholding the right amount. And if you haven’t shifted to a higher tax bracket, you can add the same percentage of your raise to your automatic savings deduction.
With a little discipline and the proper mindset, you won’t experience FOMO when your neighbors make a big purchase with their tax refund. Instead, you’ll be laughing all the way to the bank.
