Let me give you an idea of how a little knowledge about the tax code can save you money each and every year. If you're getting a tax refund this year, you’ve done something terribly wrong. If the IRS is writing you a check - it’s because they’ve been withholding too much from your pay check. That means you gave Uncle Sam an interest free loan and don’t flatter yourself - you didn’t do it out of patriotism. Like most people who get a refund, you failed to tell your employer that you have a dozen kids and want to increase the number of exemptions. That's how you get your employer to withhold less money from your paycheck. You don’t actually have to have the little darlings in your possession and you don’t get to claim them when it’s time to file - unless you’re a champion breeder with four sets of triplets.
The average tax refund this year is expected to be around $3,000. That means, on average, you were giving the government a $250 interest free loan every month - all year. And, if you’re a procrastinator and a late filer, it might take them as long as eighteen months to pay you back. Now think of that $3000 you have on your credit card. You could have been paying that off - couldn’t you? Were you giving the government an interest free loan and paying the bank interest on your credit card balance? If you’re getting a refund - the answer to that question is yes.
You should try to owe the government money at the end year and it is all the more incentive to procrastinate when you’re filing. As a matter of personal pride, I like to drop my return off at the post-office at midnight on April 15th. It can be a lot of fun and it’s a cheap date. In most large cities - it’s like going to a parade.
You only have to withhold taxes equivalent to 100% of the taxes you paid the prior year or 90% of what you owe in the current year. And that’s how you should calculate the minimum withholding amount. That way you get to turn the tables and get the IRS to give you an interest free loan. In my experience, if you owe them a thousand dollars or so, they're just glad to get your check.
Now let’s quickly do the math. Let’s say you’re getting the average $3,000 refund. But instead, you’re going to owe the IRS $2000. That’s $5,000 dollars right there - the loan you didn’t give them plus the loan you forced the IRS to give you. Now, let’s say the interest is about 15% on your credit card. Factor in the average term for each of the $250 monthly loans you gave to the tax man. It averages out to about 9 months. Anyhow, if you add it all up, you save about $500. But don’t forget that those five hundred dollars are the genuine article - they're after tax dollar. You probably would have had to earn an extra $750 to replace them.
Once you’re tax conscious, that’s how your brain gets wired. You can push your tax advantage a step further by placing that $750 in a tax favored retirement. If you do that every year, it might just add up to a tidy sum twenty or thirty years out. Of course, when tax time comes, you have to have the money to pay the IRS for that 'little loan' you took from them. If you are smart about managing your money and include it in your budget, that shouldn't be a problem.
Now I know some of you will say that you like getting a refund because it 'forces you to save.' Aside from anything else, it's a very expensive way to save. And, besides, what do most people do with their refund checks from the IRS? They treat it as a bonus and blow it on a spending binge.
Take my word for it, decrease the amount withheld from your paycheck for taxes and increase the amount you contribute to your 401K or have it automatically transferred to your savings account or use it to pay down your debt. Whatever you decide to do with the savings, it beats giving the government a free loan.
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