Your Tax Refund - Evidence of a Terrible Financial Decision

Here we are, with just a few weeks left until one of our nation’s most reviled, I mean revered, dates on the calendar. April 15. Tax Day. That day when you are reminded just when you think no one in your family cares about you, your dear old Uncle Sam is always interested in what you’re up to.

It’s also around this time that I hear from clients, listeners to my radio show, and just about anyone that pays taxes how happy they are to be getting a gigantic refund from the government. I can’t do anything but hang my head and think, “Where have I gone wrong?!”

You see friends, your refund does not represent some financial boon. It is not found money. It is money you have already earned, and it represents an interest free loan to the United States government. It also represents money that you could have invested or used for some other purpose.

I recently gave a presentation at a local company for an event celebrating National Women’s History Month. After the presentation, one attendee asked this question:

“My husband and I have more money withheld from my paycheck because we like to use it as a sort of savings account. We know we’ll get that money back in April to use for major purchases. Do you think that’s a good idea?”

Tax deferral is one of the greatest weapons we have in our financial arsenal, and guess who gave it to us? The government! I spend my every waking moment helping clients avoid, or at least delay, paying taxes. It’s not that I’m un-American or don’t want to pay my fair share. I just don’t want to pay any more than is necessary any sooner than is necessary. My advice to the sweet lady that asked the tax question was this – lower your tax withholding and invest the difference in your company’s 401(k) plan. The 401(K) offers tax deferral, and combined with compound interest over time can be quite powerful. I gave her an example of $1,000 from her paycheck.

  Bank                    401(k)

Earn                    1,000                   1,000
Taxes (28%)         -280                          0   
Save                       720                   1,000
Interest (6%)          43                         60
Taxes (28%)           -12                           0
Total Saved           751                   1,060

If you are paid $1,000, and have taxes withheld, you sacrifice $249. Over 30 years invested at 6% interest, that $249 would have been worth $19,685. Still feel like giving it away for free to the government? Conversely, if you invest the full $1,000 each year in the 401(k), in 30 years at 6% interest, your account total would be $79,058. 

 

Another added benefit of tax deferral to a retirement account is that if you make pre-tax contributions, you will lower your taxable income, which means your overall tax bill will be lower. That’s two tax benefits for the price of one! Tax deferred growth of your investment and immediate reduction of your tax bill. 

 

There’s probably not a lot you can do to reduce your tax bill for 2014 at this point. You do have until April 15 to contribute to your Traditional IRA or a Health Savings Account, which will give you deductions. But from here on out, I want you to learn this rule – large tax refunds represent a bad financial decision. Plan now to keep more money in your pocket and out of Uncle Sam’s.

 

Live Fabulously - Diva