It's tax season, and one aspect of tax preparation that directly impacts my budgeting work with my clients is how much of a refund they get.
It struck me the other day after I had several individual conversations with my co-workers about how we were trying to strategically get as little of a refund as possible for ourselves, how different this is than the opinions I hear in the non-finance world. It does sound counter-intuitive, right?
Refunds can seem nebulous, almost like magic. You don't really understand where exactly the money is coming from, but you know you look forward to it every year. What accountants understand is that when you get a refund, the money is coming from either or both of only two places:
1) Money that you yourself have paid in
This could have been from estimated tax payments if you are self-employed, withholding that your employer automatically sends in to the IRS throughout the year (you know the W-4 you fill out when you start your job?), or money that was carried forward from a previous year.
2) Refundable tax credits
Most tax credits can bring your tax liability down to zero, but if they go over what you owe the remaining amount will not end up in your pocket. However, refundable credits like the Earned Income Tax Credit, the American Opportunity Tax Credit, or the Additional Child Tax Credit are considered "payments" on your tax return, so they can result in cash back in your pocket.
Let's say that you are going to owe $2,000 in tax. You end up with $3,000 of refundable tax credits. That means that you are now going to get a refund of $1,000. Now, what if through the withholding on your paycheck, you had already paid in $1,200 on your own throughout the year? As a result, your refund is going to be $2,200.
Getting a check for $2,200 is a BIG DEAL. How exciting! What do you do with it? Pay off a credit card? Buy a new iPad? Put it in savings?
Think about it. More than 50% of that refund is your own money that you are getting back. In fact, much of the time our refunds are actually just money that we ourselves have overpaid.
How about you? Do you depend on that money to pay off credit cards that have accrued during the year? What you may not fully realize is in the meantime, the government has used your money to get a return on investment, while you have paid interest to credit card companies.
Or maybe you understand that you are overpaying during the year, but you continue to do it knowing that you are not good at saving, and if you get it in your paycheck you will just piddle it away during the year. Having one big chunk you can use at one time for something that you otherwise couldn't afford is appealing.
This is smart thinking in many ways. It's the kind of forward thinking that it takes to make good investments. So here is my suggestion--take that understanding of depriving yourself now for a greater reward later, and apply it in a way that benefits you even more, rather than giving the government a free loan.
How accountants strategically minimize their refund
Accountants certainly use every legitimate avenue they can to lower how much tax they owe, but they also try to make it so that they get more back during the year rather than all at the end. This way, the money is in their control and they can make more money with that money.
Here's how to do it:
1. Look at line 16 of the 2019 1040. This is your total tax that you owe
2. Look at lines 17-18 to see where your "payments" are coming from.
If any of the money that you yourself have paid in is causing some or all of the refund, reduce your withholding. You can do that by asking your employer to fill out a new W-4. If you need advice on how much to reduce it, consult a tax professional.
Let's use our previous example.
$1,200 of your refund was out of your own pocket.
To maximize your money's effectiveness, divide that $1,200 by 12 months of the year; it comes to $100/mo. Here are a few ideas of what to do with that money:
--Set up an auto-deduction from your paycheck to go into a savings account. At minimum, even 0.2% back is better than nothing, and it is available when you need it.
--Another option is to transfer it to a money market or brokerage account that will give you a better rate of return.
--Or, take that $100 and increase your contribution to your IRA or 401k. This is the most "boring" option, and yet absolutely necessary in the long run.
However you invest it, set it up automatically so it just happens without having to do anything on your part, easy.
The key is to be proactive with your money instead of using the government as the proverbial coffee can.
Disclaimer: While I do not do anything for JD Financial that is in competition with my full-time job as an accountant, if anyone needs help looking at their already prepared 2019 returns to see how they can be strategic with their refund, don't hesitate to reach out!