Although one firm advertises Get Your Billions Back America, getting a tax refund can actually be harmful to your financial health. Did your tax preparer ask you if you had participated in a company-sponsored retirement plan? Further, did they mention reducing your taxes by taking out a traditional IRA? If so, did you have the cash to do it? Did you get a refund?
Fallacy of a Fat Tax Refund's Benefits
You may hope to hear that you’re going to get a tax refund. From your emotional—some might say behavioral—side, hearing that you’re going to get a refund sounds like found money. It may even conjure up ideas on how you could use the money now. However, from a financial perspective, a refund represents a lost opportunity cost for things you could’ve done in the past. Also, It means that you paid more than necessary. Often tax professionals sell their value on helping you get a tax refund. I believe the value you want is paying as little as is legally necessary. I believe their value should actually be reducing your overall tax bill and not getting a refund.
Do you actually know how much you paid in taxes?
It’s possible that through tax planning you may decrease your tax burden to the point where you pay less in taxes and get no refund. If you were looking for a refund, you may be disappointed. However, you paid less in taxes and enjoyed the money throughout the year. I’ve had that conversation with some people who did not understand how the tax thing works. (For related reading, see: How Is Income Taxed Differently From Wealth?)
The Harm of the Tax Refund
Did your tax preparer suggest that you take out an IRA to further reduce your income? Some people find that they are getting a refund, but don’t have the cash to pay for an IRA. When they get the refund they have other things in mind for using the money. They may be unaware that if they are a W2 employee, they can go to their employer and change their withholding by a specific dollar amount. Let’s say that amount is $225. You can then set up an automatic withdrawal from your checking account into an IRA. This would reduce the prior tax year’s refund to close to zero. This is referred to as tax planning. Rather than simply prepare your taxes as the majority of people do, this is a proactive approach to looking at the tax code in order to best leverage its opportunities to reduce your income tax.
The average tax refund in 2016 was $2,945. That means an approximate average of $245 per month was sitting in an account where that taxpayer received no return and no future retirement benefits. The refunds roughly equate to half the available amount to invest in a traditional or Roth IRA. Money is invested in that account could be invested and grow tax-free.
There’s even a potential multiplier. It’s estimated that fewer than 50% of the people who have the opportunity to save in an employer-sponsored retirement plan do so. Many of those plans provide a matching contribution. In fact, the tax policy wants you to do things like this; it's why it offers you tax incentives, like advantage retirement savings. If, for example, an employee contributed $10,000 to a retirement account that could've been matched by the employer by 50%, the taxpayer would now have a balance of $15,000. Those lost funds would have cost them nothing to obtain.
Behavioral economists would weigh in and say that these refunds often have a special place in the taxpayers mind. They call this mental accounting. That's where dollars like a refund are considered plus money and could be used for things like a new TV or vacation or some other item that has a more present benefit. However, what would happen if that person took their own contribution, $2,500 for example, plus the matching contribution and invested it, getting a 6% net return over a 40-year period? They would have over $600,000 to help pay for retirement. (For related reading, see: How 401(k) Matching Works.)
Tax Refunds and College Planning
Have you wondered how you’re going to pay for the high cost of college for your child or grandchild? If you’re a parent, one of the ways to use your tax refund is to invest it in one of the many tax-advantaged savings tools. Many of these work like a Roth IRA; it's tax-free growth and no taxes are applicable if the fund is used for qualified education programs. That $225 would provide a nice, systematic way for you to save on ongoing basis. This should allow you to enjoy the benefits of a dollar-cost averaging approach to investing.
Dollar-cost averaging involves continuous investment in securities regardless of fluctuation in price levels of such securities. An investor should consider his or her ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.
Do you have a rainy day fund? That $225 per month can help build one up.
(For more from this author, see: How Compounding Benefits Your Retirement Savings.)
This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.