Sunday, February 8, 2015

Tax Season... More like Refund Season!

I'm sure you've all seen the H&R block commercials. They air them pretty much nonstop about this time every year. You guessed it, tax season is upon us once again, and all of these companies really want you to use their services to ensure you get the absolute highest possible refund...

Some of them try a little too hard...

But should you really be getting that high of a refund? Let's stop and think about how taxes work for a second. Let's say you worked really hard for a year and earned $100 (unrealistic, but it makes the maths easier for the non-math savvy to understand). Now let's say you owe a total of 20% tax to government agencies. Forget about state, federal, and other tax types for a moment, and just focus on the numbers. You owe $20 in taxes and get to keep $80. That's pretty simple, right? The problem is that we don't just pay that amount all at once because no one would be responsible enough to save all year for their taxes... we pay our taxes in increments - a little bit out of each paycheck. The trouble with that is the rate isn't exactly constant and can vary based on location, total pay, and a plethora of other factors. There is no way to know exactly how much we will end up owing during tax time, so we fill out forms that aim to make an educated guess based on previous income, living situations, and overall awesomeness (or the opposite) at life.

This is where the whole thing goes south. I was always taught, as most people are, that I should "claim 0" on my W-4 forms so the maximum tax is withheld. Hold the phone, why would I want the maximum tax withheld? Simple, you reply, because you will get a huge refund at tax time. At first, this sounds awesome, who doesn't love refunds? Um, me, that's who. Do you know what a "refund" actually means? It means that someone owes me money, and that someone happens to be the IRS.

I'd like to think I am pretty responsible with my money. I save, shop smart, and live well within my means. However, I know plenty of people who live paycheck to paycheck. I'm not here to brag or to judge, but an extra bit of money each pay cycle would go a long way with a lot of people. So why are people giving that extra money to the IRS each week just to get it back later (without interest)?

Let's look back at those simple numbers again... If you make $100 and will probably owe 20% in taxes, you should shoot for paying exactly 20% at each paycheck. Of course, it's impossible to know exactly what you will owe, but those forms do a pretty good job at guessing. Why is this so important? Let's look at some more numbers, just for fun.

There are 52 weeks a year, but you take off 2 of them, so you will get 50 weekly paychecks of $2 each. If you claim 0 dependents, the maximum tax will be withheld from those paychecks. That could be easily be 35%. Now, you are paying 35% taxes all year, keeping only $1.30 each paycheck.

Yes, yes they are...

At the end of the year, you have kept 65% of your $100 annual pay which amounts to $65. However, your savings, living expenses, and a few of life's unexpected events cost you $75. That excess cost was likely absorbed by your credit cards.  No big deal, everyone has credit card debt, right? Then comes tax time, and you have a huge refund waiting for you: $15. One thing you might be aware of... people who are constantly out of money are not very good at keeping it once they find some. So you spend that money on a new TV, or a vacation, or to remodel the bathroom. 

Let's say you actually decide to be responsible and you try to pay down your debt. If this year you added $10 to that pile, it was probably already pretty high from the previous years. Assumptions aside, you will owe more than your $10 debt. You will owe interest on that debt - likely 15% or more. That bill just climbed from $10 to $11.50. So you pay that off and come out ahead by $3.50. Hooray! Now let's see how that year could have gone...

Since you filled out your W-4s more accurately, you only had 20% withheld each paycheck, so you got 50 paychecks of $1.60 each. At the end of the year, you made $80 and ended up neither owing tax nor getting a refund. Also, that extra little bit in each pay check was enough to pay for all of your expenses for the year, so you didn't add any debt to your name. In fact, you walked away with $5.25. Wait, how did $80 - $75 = $5.25? Easy, rather than blow that excess money, you invested it all year to the tune of 5%.

So there you have it:
 Plan to get a refund and get 3.50% of your annual salary.
Plan not to get a refund and get 5.25% of your annual salary.

Of course, all of these numbers are totally made up estimations, but for the the mean American household income of $54,000, smart planning could be an additional $1000 in your pocket at the end of the year. Taxes may be unavoidable for most, but you have the advantage of knowing they are coming. Think ahead, plan out your expenses, and stop getting so many refunds.