It's the end of July, so naturally I'm thinking about taxes. That may seem strange to some of you, but this is normal for me. I start trying to figure out where we will end up at the end of the year, and whether we'll get a refund or have to pay Uncle Sam when we do our taxes next spring. This year is different. This year I left my stable corporate paycheck to start my own business. This year I'm almost positive we are getting a refund. Probably a pretty sizable one. Unlike the last few years when we've had to write big checks, Uncle Sam is going to be sending us money. (cue the party music!)
Sounds awesome, right? Not quite. 75% of tax filers cash in their "IRS savings account" every year and thank Uncle Sam for letting him borrow their money interest free, all year. What?!? Yep, that's right. A tax refund is an interest free loan to the government. It's YOUR money. Only you can't take it out until next year. So it's worse than a savings account, it's more like a CD that pays you NOTHING. As you can tell, this really bothers me. However, I'm writing this to let you know what you can do NOW to avoid getting a big refund, and why even if you don't do anything, it might not be all that bad.
What you can do NOW to avoid a big refund
When you started your job a long time ago, you filled out a W-4 so that the IRS would know how much money to take from each of your paychecks. The lower the number of allowances you claim, the more the IRS takes out. Many of you probably put 0, like you did at your first job in high school. That's how you get a big refund. If your circumstances have changed since you started your job (or since high school), you may want to revisit. If you've gotten married, bought a house, or had a child, it's likely that 0 isn't your number anymore.
If you want to make changes during the year, the IRS has a withholding calculator that let's you estimate where you will be at the end of the year, compared to where you are now, and suggests how many allowances to enter on your W-4 so you get a smaller refund (or owe less if you owe). This calculator works best if you (and your spouse) have only worked 1 job each during the year, you don't have a lot of variable income, and your tax filing is relatively straightforward.
Once you adjust your withholding, you'll find that you may have more money in your paycheck. This is a great time to set up direct deposit to a REAL savings account, or even increase your retirement plan contributions. But what if you just don't have that discipline or you really like getting that refund?
So maybe a refund isn't all that bad anyway
I'm starting to come around on the refund concept. With today's low interest rates, the most you're probably earning on your regular savings account is around 1.0%. If you get an average refund of $3000, 1% equates to a loss of around $30 for the whole year, and that's before you pay tax on your interest income. If you adjusted your withholding and saw more money every check, you might be tempted to spend it. That extra $100 in your paycheck would probably go towards all those little everyday expenses that you can't even remember when tax time comes around.
Instead, think of what you can do with a large check in the spring. Have a plan for it.
- Pay down debt - many people use their refund to pay off holiday expenses, high-interest credit cards, or other outstanding loans to help decrease expenses going forward
- Take a vacation - do something that inspires you and that will provide cherished family memories forever
- Kickstart your emergency savings - it's incredibly satisfying to deposit a large check that gets you halfway toward your goal or more
- Donate it - find an organization that inspires you. It might even be tax deductible next year.
Let's face it, we would all like to make rational, by-the-numbers, decisions in our finances. Instead, we are human beings that succumb to daily temptations and might need a little help from Uncle Sam once in a while. Reach out if you'd like financial coaching to help you through decisions like this that come up throughout the year!