There are many myths about income taxes that are just plain wrong. But there is one income tax myth that is likely the most hurtful to you financially – and that is the idea that a big refund should be your goal. The actual goal, counterintuitive as it may sound, should be to owe some tax when you file your return.
You may have heard this explanation before: When you have a big refund every year, you’re effectively loaning money to the government throughout the year, and getting nothing for it. And then when you get that big tax refund, what do you do with it? The responsible thing would be to put it in some sort of savings vehicle – but how many folks actually do this? Statistics show that far too few of us think saving first when we have extra money. Too often we use the money to pay off a credit card (which is still a good thing, but perhaps we shouldn’t have built up the credit card balance in the first place) or worse, we use it to treat ourselves.
Let’s examine the situation for a moment. If you have a refund of $2,000 (for example) when you file your tax return, that means every month throughout the year you handed over $166.67 to the US Treasury that should have been in your pocket. The US Treasury is happy to have it: they report the balance to Congress and Congress spends it.
And then, when you get the refund you wind up spending it on something that provides short-term pleasure rather than long-term benefit.
What if, instead of handing it over to the US Treasury, you change your withholding so that you can now receive an additional $166.67 each month? You could put this money into a savings vehicle, an IRA for example. Now, you could actually reduce your taxes even further by deducting the IRA contributions from your income. So if this reduces your overall taxable income from $80,000 to $78,000 (for example), the resulting tax is reduced by $500 (for a single filer, 2015 rates). So not only have you added $2,000 to your savings, you could add a total of $2,500 to your savings (adding another $125 of tax reduction!).
If you did this for 20 years over your working lifetime and earned an average 5% return, you’d have built up an extra $82,000 in an IRA.
Can’t I just do this at the end of the year?
But you may ask – couldn’t I just make the IRA contribution after I get my tax refund, taking the deduction while I’m filling out the return? Of course you could, but how often have you done that in the past?
What I’m suggesting is that you might set up an automatic contribution to an IRA every month. You’ll want to change your W4 on file with your employer so that less tax is being withheld, so that you’ll have the extra money in your take-home pay.
Then by setting up the automatic contribution you don’t have to make the choice to contribute to the IRA at the end of year – you made the choice when you set up the automatic contribution plan. Since you’re already accustomed to living with that same income (the same amount of take home pay), you’re no worse off than you were before, and you will be building up your savings to boot.
So the real goal should be to wind up with a zero tax refund – or possibly even owing some tax at the end of the year. If you owe less than $1,000 when you file your tax return, it’s as if the US Treasury has lent you that money, interest-free, for the year. It’s a reversal of fortunes, all because you realized this is an income tax myth.
If you put that extra $1,000 to work earning 3% (over time), you’ll pick up an extra $375 over the same 20-year period – it’s not a lot, but still money that could be yours instead of going to the government.
Now, there’s the question of how can the US Treasury get by without your loan every year…? I suspect that somehow things will work out just fine, because very few people will do this and the impact will be minimal in the scheme of things.