It’s very ironic how the month of April is financial literacy month and is also the same month we file our taxes.
Many of us fear tax season because this is the time of year we will pony up and write a check to good ol’ Uncle Sam. However, there are also millions of us who look forward to this time of year because it means one thing: Tax return baby!
Why Do We Get a Tax Return?
In 2016, the United States Government sent out 40 million tax returns in the amount of $125 billion! Divide that out by the number of tax returns which were filed, and this comes out to be $3,128 refund per return.
But why do we get a refund?
The simple truth is you sent the government too much money throughout the year and therefore they are refunding you what you overpaid.
However, it’s actually a little more complicated according to my wonderful CPA, Earl the tax-man. The current IRS playbook (i.e. the tax code) is over 74,000 pages long! To make things even more complicated, the IRS continually updates the tax law every year and many of the tax laws are based on our own perception, meaning how you and your CPA perceive the rules.
But I LOVE My Tax Refund
I don’t blame you.
Who wouldn’t love a bonus in the Spring often in the thousands of dollars? If you file online, you can usually see how much you’re getting back within the hour. It magically comes in between the holiday hangover and the upcoming summer vacation you have planned. Also perfect timing for car dealerships, furniture stores, and electronics warehouses to unveil their Tax Refund Sales Season 🙂
To add the the love of the refund, don’t we also feel a little win by taking back some of our hard-earned money from the good ol’ U.S. government?
Take that Uncle Sam! You aren’t going to get me this year!
The truth is the IRS is going to get their money no matter what. You aren’t getting the upper hand, you aren’t pulling the covers over their eyes, and you’re not coming out on top. In fact, it’s just the opposite – they absolutely love paying you a tax refund each year.
Would You Do This?
Think about this…
Let’s pretend you and your best friend Sam are together one afternoon for lunch, and Sam asks you for a loan. He can’t tell you what it’s for but promises he is good for it and he will of course pay you back.
Although Sam is one of your best friends, Sam is also one the worst money managers of anyone you know. He is deeply in debt, owes bad people money, continues to go deeper into debt, and doesn’t seem to care about it at all. In fact, he is currently so deep in debt that he will even admit to you there is no possible way he will ever pay it off in his lifetime.
How would you feel about loaning Sam money?
The truth is this Sam isn’t really your best friend, but rather he is your Uncle Sam, and this is very similar to what happens with your tax refund.
And why does Uncle Sam love sending you a refund each year?
Because you can bet he is generating money with your tax refund you loaned him and he isn’t paying you a dime to borrow your hard-earned money. In fact, you’re actually paying to lend him money in the form of interest on debt or missed opportunity costs.
Related: The Opportunity Cost Formula
Your Tax Refund is….
It’s not a good plan.
As I mentioned above, the average tax refund in 2016 was $3,050. This essentially means you loaned your Uncle Sam $255 each month at 0% interest and told him to simply pay you back “sometime next Spring.”
How nice would it be to have a $255 raise each month and what would you do with that money?
Instead of loaning your money to the U.S. government at zero percent interest, what if you were to invest that money throughout the year?
How much quicker would you have saved for that one thing that’s been on your mind?
How much extra did you pay in interest last year while the government held onto your money at zero percent interest?
You don’t need the government, who has a horrible financial track record, managing your money for you. I promise you can save on your own if you make the decision to do so.
However, easier said than done, right? Remember, there are over 74,000 pages in the U.S. tax code. How could you possibly know the right formula to make sure you break even each year?
The truth is you can’t. It’s impossible and some of the brightest financial planners and CPAs in the country will tell you the same. But there is still something you can (and should) do.
IRS Tax Calculator
The IRS has provided some help by putting together a withholding calculator on their website which is intended to have you withhold the recommended amount each month. Although this is not an exact science (even for the IRS), it’s a start in the right direction so you’re not loaning thousands of dollars to the IRS each year.
The $1,000 Rule
This is my opinion and I am of course an expert on my opinion 🙂 , but Andrea and I try to live within the $1,000 rule.
This means we would rather owe the IRS $1,000 versus getting $1,000 back in our tax return. We are also okay falling somewhere in between.
Full transparency, this year was an interesting tax year for us. In the past, we have continually fallen within our “rule”, but the 2017 tax year proved to be a unique year.
Without being too technical, we increased our gross income AND we converted a non-deductible IRA to a ROTH IRA which resulted in our taxable income increasing even more. The result is we owe the the IRS $4,500 this week.
We did have a feeling this would be the case and we planned accordingly throughout the year and intentionally set aside extra money for taxes, BUT we of course did not set aside quite enough 🙂
This is also why we have an Emergency Fund.
However, we are also pleased we didn’t loan the government any of our hard-earned money. We know when we owe the IRS money at the end of the year, this means we also were efficient with managing our income versus loaning it for free to one of the worst money-managers on the planet.
Make the Change
This makes sense.
You work way too hard and you’re way too smart to send your money to the government on purpose in the form of a forced savings plan.
It’s time to make the change. Call your HR rep, update your W-4s, and utilize your income in a much more efficient way. If you’re self-employed, pay your taxes quarterly to avoid overpaying throughout the rest of 2018.
Related: Utilize Sinking Funds for Taxes
Lastly, if you need help, ask for help. Andrea and I are not great at taxes but we know someone who is (Earl the tax-man). This is why we pay him to help us make the best decisions with our withholdings, thus saving us thousands of dollars in the form of tax-efficiency.
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