It’s the most wonderful time of the year – time to dig out your receipts, examine bank statements, call up your accountant, and “render unto Caesar the things which are Caesar’s”. It’s time once again for that most thrilling and enjoyable civic duty – the filing of income tax returns and paying of taxes.
While it is on the minds of many I want to share my advice to my fellow tax-paying Americans for 2013 in anticipation of our next season of tax filings: Set yourself up to receive a refund next year. Increase the tax withholding on your paycheck (via Form W-4). Refunds are good.
You’ve probably read somewhere (or many somewheres) that refunds are bad and to be avoided. Some of the reasons given include:
- “You’ve given the the federal government an interest-free loan” – MSN Money
- “You overpaid your taxes during the year, essentially giving Uncle Sam an interest-free loan” – dailyfinance.com
- “Getting a burst of money at once is exciting, particularly in this down and out economy, but financially speaking, it’s just not smart” – oprah.com
- “If you get a large tax refund, you’re allowing the IRS to take too much money out of your paycheck” – Dave Ramsey
Technically speaking, the conventional wisdom is correct – if you receive a refund you have overpaid the government during the year, for most people via wage withholding on paychecks. However, this overpayment isn’t necessarily a bad thing. There are a number of reasons why receiving a tax refund is a good thing.
- Opportunity cost – In today’s savings environment, you’re not likely to find a savings account paying even 1% interest. On that basis, if you received the average refund of about $3,000 you missed out on a total of about $15 of earnings. You’d be far better off skipping a dinner out once during the year and saving the $15 you would have spent. Of course, there are other investment options but even earning 10% would bring in about $150. Not chump change, but also not life-changing and the earnings are far from guaranteed results.
- Peace of mind – By overpaying during the year you are protecting yourself from potential penalties and interest at tax time. Additionally, it’s easier to handle an unexpected windfall than to pay an unexpected bill when you file your return. It also feels a lot better.
- There are safe harbors that taxpayers can aim to meet which avoid possible penalties and interest. These are relatively simple. Meet any of the following criteria and you won’t be hit with a penalty:
- You owe less than $1,000 on your tax return
- You paid at least 90% of your total tax liability due during the year
- You paid at least 100% of your total tax liability from the prior year (prior year tax return must have covered a full year)
- If your income has increased or all of your income is from wages these safe harbors are relatively easy to hit and the standard withholding should put you in the safe zone come tax time. However, if you have self-employment income, rental property, or other income activities that do not include income tax withholding you will either be seeing increased compliance and stress levels during the year to calculate and make estimated tax payments or a potential tax hit at the end of the year for underpaying on these activities. My advice is to over-withhold on wages and you can cover these sort of activities without having to prepare financial statements throughout the year.
- There are safe harbors that taxpayers can aim to meet which avoid possible penalties and interest. These are relatively simple. Meet any of the following criteria and you won’t be hit with a penalty:
- Forced savings – If you have extra tax withholding during the year your take home pay during the year will be lower. This is a great opportunity to reduce expenditures and learn to live on a lower budget. On top of the refund you’ll get at the end of the year you will also reap the benefit of learning to live (literally) below your means – a lesson that is likely to carryover from year to year. American households have an average of about $7,000 of credit card debt so living below our means would seem to be a skill that could use some practice.
As Tupac said – I love paying rent when the rent’s due. A forced savings mechanism like over-withholding during the year will leave you with a positive surprise when you file your tax return and leave you with a rainy day fund or vacation windfall rather than a tax bill to pay.
John P. Anderson
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Living in San Diego forces all us leftover adventurers, wannabe artists, surf-addicts and otherwise curious to live ever closer to the bone, year by year. It’s healthier, anyway, than having a bagful of cash and nothing better than a stop at Le Cafe to spend it on.
I don’t think that our credit card debt is a reflection of profligacy. Much of what I have read and personal experience link that debt to depressed wages, a broken safety net and extended periods of unemployment and underemployment. Americans are using their credit cards for necessities- car repairs, medical emergencies, even day to day living. The tax refunds, while certainly very welcomed, have not ended up as stimulative to the economy as hoped because so many of us have used them to pay off credit card debt. The banks who receive those payments are not stimulating the economy either.
Undoubtedly there are many that use credit debt for needed expenses. For those with the ability to reduce discretionary spending or build a savings account I simply wanted to highlight tax refunds as a good opportunity to do so.