In all my years of working for a Certified Public Accounting Firm, it never ceased to amaze me the number of people who like to get a big tax refund from the Internal Revenue Service (IRS) every year. And my own family was just as guilty of this.
I know this will shock you, but…
In my opinion, the very best position to be in (from a tax standpoint), is to owe as much as possible with your income tax return every single year, without being subjected to interest and penalties from the IRS.
I know that thought may make you cringe, but for most people this means that you have reduced your tax withholdings, thus enabling you to keep as much money in your own hands, working for you, throughout the year, and when April 15th comes around, it’s simply time to pay the remaining taxes you owe to the government, with no interest or penalties being charged.
Let me explain...
Most people OVERPAY their income taxes throughout the year, usually through tax withholdings at their current job, only to get a very large refund in March or April of the following year when they file their income tax returns.
Did you realize that this money was yours all along, and that you basically loaned it to the government, interest free, throughout the year?
In effect, the IRS is giving you your own money back, WITH NO INTEREST, when they send you your refund check.
When was the last time the IRS sent your refund along with a note saying, "Thank you for loaning us your money all year long. Here is your refund check along with some interest earned on that money."?
Probably, NEVER! (Unless you had some kind of special circumstance.)
If your income tax refund is over $2,500 every year, that’s over $200 you are loaning the government, interest free, every single month. If your refund is over $5,000 every year, that’s over $400 every month that you are loaning the government without them having to pay you a dime of interest.
That upsets me, but most people don’t care...they say, “Oh well, my tax withholdings are a forced savings account for me, and I’d rather be safe and overpay.”...
Or they may say, “I just don’t want to owe!”
My response to that, if you want to be safe, is to reduce your tax withholdings, get that money in your own hands each and every month, invest it in a money market account or certificate of deposit (CD) with little or no risk, and at least let your money work for you a little bit instead of just giving it to the government in the form of an interest free loan.
That way, you haven’t spent the money, it’s still there when you file your tax returns, and it has even grown a little bit for you along the way, instead of sitting with the IRS doing nothing for you.
Then, if you need it to pay the IRS a little bit when you file your tax return, it’s there for you.
As a side note, I did have one client (several years ago when I was still actively preparing tax returns) who refused to pay a dime in income taxes throughout the year...every single year...which is also perfectly legal.
He did, however, get hit with significant interest and penalties on his tax liability every single year. His feelings, “I can make more money in the market and with my own investments by keeping my money in my own hands, than the IRS can ever think of charging me in interest and penalties on that money!”
And he was right...he was a multi-millionaire and paid millions of dollars in taxes every year, and usually made significantly more money on his investments than the IRS ever charged him in interest and penalties.
With that being said, did you know that there is only a certain amount of taxes you are required to pay throughout the year, without incurring interest and penalties?
I’ll try to break this down in "average person" terms so it is easy to understand...
In general, every year, in order to avoid being charged interest and penalties for underpaying your taxes, you are required to pay (or have withheld) the smaller of...
1) 90% of your current year’s tax liability, or
2) 100% of the previous year’s tax liability.
If you are a high income taxpayer, you would substitute 110% for the 100% in the previous sentence.
That doesn't mean you won't owe on your tax return, it just means that you won't get hit with additional interest and penalties on your balance owed.
Therefore, if you are receiving substantial tax refunds every year, and you want to take control of your financial life, I would suggest that you change your W-4 at your place of employment and have less taxes withheld from your paychecks.
A W-4 is a form that an employer uses to estimate your tax liability and how much should be withheld from your paychecks.
If this amount is continually too high, then you need to fill out a new W-4 form with your employer to change your tax withholdings (in order to have less taxes withheld every month), and therefore increase your take home pay.
I’m sure you could use this money for something better than an interest free loan to the government...maybe pay off some credit cards, pay down your mortgage, purchase something you’ve always wanted, or simply stick it into an investment of some sort, depending upon your comfort level of risk.
Whatever you do, please seek the advice of a competent tax professional, in order to completely understand your personal tax situation and properly complete your W-4 form.
If you need help finding a competent tax professional, I will be happy to help you find one.
To Your Success...