Tax season can be nerve wracking and tedious for some. Those without a company withholding income taxes throughout the year need to make quarterly tax payments to the IRS, while others who haven’t planned well may not have prepared for the tax burden come April.
But for approximately 70% of U.S. taxpayers, a refund check is on its way shortly after filing taxes. And according to the Motley Fool, the average tax refund is nearly $3,000.
Great, right? Well, not if you are paying down debt or investing.
Many people do not realize it, but a tax refund is simply the IRS giving back the money you should have pocketed several months prior. The IRS is not giving you money out of the kindness of their hearts. That would be a first!
Think of it this way. Let’s say you owe your friend $100, and he has agreed to let you pay it off over the next year.
- You pay him $10 every month. 12 months * $10 = $120.
- A couple months after you make your last payment to him, he gives you $20.
It’s nice to get $20. But it’s a refund because you paid him more than you owed the previous year. Why pay him $120 when you only owe $100?
The same principle applies to paying taxes. When someone gets a $3,000 refund from the IRS, it’s because they overpaid their taxes throughout the year by $250/month.
While some don’t realize this is the reason for the refund check, others understand and do it anyway. They like the lump sum each year. But the problem with this method is you receive the same amount of money in the end, the payout is simply delayed.
When paying off debt or investing, this costs you in the long run.
The Math – Why Large Tax Returns Are Bad
How much do you give up by waiting to receive a tax refund? Let’s use $3,000 for the example, and assume two imaginary people make the exact same salary.
Example 1: Sam does not adjust his tax withholdings at work in 2017, and receives a $3,000 tax refund from the IRS after filing his taxes in January 2018.
Example 2: Sally adjusts her tax withholdings at work in 2017, which means each paycheck is slightly higher because less tax is being withheld. If she adjusts her withholdings just right, she can add approximately $250 to each monthly paycheck throughout the year, meaning she will get her $3,000 before 2017 is even over.
The value in example 2 is in receiving the money earlier. When paying off debt or investing, the earlier you can put your money to work, the less interest you will pay on debt or the more your earnings will have a chance to compound.
If both Sam and Sally wanted to invest their $3,000, Sally would be better off, assuming 7% annualized returns. Since Sally can invest $250 each month, whereas Sam has to wait until January 2018 to invest, Sally already has $3,116 by the time Sam finally receives his $3,000 from the IRS. If Sam and Sally continue this for the next 30 years, Sally would have over $11,400 more than Sam simply due to investing earlier, not more.
Investments are never guaranteed returns…you can lose money or make much more than 7% in a given year. But what about debt, where you have the certainty of a specific interest rate?
Let’s assume both Sam and Sally have $50,000 remaining on a 10-year student loan debt at 5% interest when 2017 begins. Sally puts $250 extra to her loans each month throughout 2017. Sam has to wait until January 2018 to apply an extra $3,000 payment to his student loans.
In January 2018, Sally has $42,654.64 remaining on her loan while Sam has $42,737.14 remaining. They both contributed $3,000, but by contributing earlier Sally eliminated more interest than Sam and saved $82.50 in a year simply by keeping her money instead of loaning it to the IRS interest-free.
If they continue contributing an extra $3,000 per year to their student loans until it is paid off, Sally will pay off her loan after 75 months (6.25 years) and after paying $8,315.57 of interest. Sam will pay off his loan after 78 months (6.5 years) and after paying $8,895.65 of interest.
By simply taking her money throughout the year in her paychecks instead of waiting until tax return time, Sally shaved off 3 months and $580 of interest.
How To Adjust in 2017
The good news is most employers make this very easy to adjust, whether online or by calling payroll. To change the amount your employer withholds from your paycheck, your withholding allowance needs to be adjusted on IRS form W-4.
Once you find your current withholding allowance, you can use an allowance calculator like this one from TurboTax to determine how to adjust it.
Important rule of thumb: if you are adjusting it up (for example, from 1 to 2), this will result in less tax withheld and more money in your paychecks.
My wife and I adjusted our withholdings several years ago and it helped us pay down our student loans a couple months faster. We still receive a small refund each year since it’s difficult to withhold exactly the right amount, but we no longer get $3,000 tax refunds because we understand the value of receiving the money earlier.