Tax Refunds: Why Smaller is Better

FROM DEPOSITACCOUNTS.COM

Some people do a little victory dance when that tax refund check comes in the mail. But truth is, in the long run there’s nothing really to celebrate.

"Getting a refund check for $5,000 or more each year is like an addictive habit for some people. They get a rush from a big check arriving in the mail like they hit the lottery. Unfortunately, it’s just their own money they are getting back," says Jon Ulin, founder and managing partner of Ulin & Co. Wealth Management.

"We advise our clients to pay in only enough in federal income taxes from their paychecks throughout the year to come as close to breaking even on their federal income tax liability as possible. Do not overpay your federal taxes," says Ulin.

At the end of the year, if you’re a bit short on your federal income tax obligation, you simply just send a check to the IRS. If you’re getting more than $1,000 back in refunds from the IRS, then this proverb applies to you, "To Uncle Sam, you will neither a borrower nor a lender," says Ulin.

when you get a refund, it means you gave the IRS an interest-free loan for the year
Maybe you convince yourself that the refund money will be used to pay for a vacation, knock off some debt, or make house or car repairs. But when you get a refund, it means you gave the IRS an interest-free loan for the year. "Anyone else, even a bank, would pay you interest on the money. But not the IRS, it returns only the amount you overpaid, regardless of how much money you gave or how long you ‘loaned’ them the money," says Richard Reyes, a certified financial planner with Wealth & Business Planning Group.

Short-term gain can mean long-term regret

Your money being held by the IRS is not liquid. If you have a job loss or personal emergency, you can’t just call up the IRS and ask them to send you your money when need it most.

Instead of giving Uncle Sam a loan, you could be investing that money or paying bills. Take for example, if you have a credit card debt charging you 18% per year, you would save yourself $900 in interest payments by paying off your debt, rather than overpaying your federal income taxes, says Ulin.

Then too, if you defer less in federal income taxes and put your money to work in a before tax retirement account, such as your employer sponsored 401(k), you could end up saving a decent amount of money in federal income taxes based on your personal blended tax rate, adds Ulin.

How to get your withholding right

Estimate how much in federal income taxes you will owe for the year and then divide that amount by the number of paychecks you expect for the year. If your income and deductions do not change much from year to year, you can simply look at what you owed in federal taxes for last year and allocate the same amount for this year but increased for inflation if your income is adjusted up as well, says Ulin.

Most people pay the bulk of their annual tax bills through payroll withholdings. Through this process, a percentage of your pay is taken out each pay period and sent to the IRS where it is credited toward your final tax bill. Review your employer W-4 withholdings at least once a year. Many circumstances can affect the amount of tax you’ll eventually owe, says Ulin.

The IRS has a withholding a calculator that can help you figure out how much should be taken out. However, "Most times it will still have you withholding too much. My bias is to work with a professional to get it within the right range," says Chris Hardy, managing director of Paramount Tax and Accounting.

Also, once you complete the withholding calculator and you find that you are between exemptions, you can choose a lesser exemption amount and add a flat dollar amount on line 6 of the W-4 before turning it in to your employer.

If you’re getting substantial refunds each year, talk to a tax professional to make sure you’re claiming all the exemptions you can.

"I recommend that you increase the number of exemptions you claim by 1 for every $2,000 of tax refund you get back. Then when your deductions change, take the extra money and put part of it in a savings or investment account. At the end of the year, you will still have the money and you will have earned interest on it," says attorney Edrie Pfeiffer, an attorney with Hampton Roads Legal Services.

Another source of help, says Jayson Mullin, CEO of Top Tax Defenders is the IRS’ "lock in" department at 855-839-2235. "They may be able to walk you through how many allowances you should be able to take. If the agent is wiling, they can access your past year tax returns and use this information to calculate a reliable allowance amount."

Finally, points out Hardy, "The majority of people focus on preparing their tax return, not tax planning. Tax planning is where you can get the biggest ROI for your money. April 1 is not the time to be tax planning for the prior year."