I did my taxes early this year. As soon as all of the documents were available online, I went ahead and filed through an online tax software.
When I saw that I was getting a hefty return, I started feeling good about myself. I was pretty excited when I saw the total Federal + State was much bigger than I expected. I have $x,xxx more dollars than I thought I did!
While it is certainly a good thing that I’m $x,xxx richer, a big tax return means I messed up big time somewhere and could have been $x,xxx richer earlier in life. I shouldn’t be celebrating, I should be reviewing my behavior to find out what I did wrong.
My tax withholding was way out of balance.
Let me put this in perspective. Imagine you buy a car. It was supposed to cost $5,000 but you accidentally pay $10,000. Then when the car dealership pays you $5,000 back a year later, you get excited and pretend you made money off the deal.
In reality, you let someone else have control of your money for a year. You missed out on the opportunity to use it for your own financial benefit. Whether you would have invested it, paid off debt, donated it, or simply had an emergency fund in place, you missed out on some opportunity.
In another article I talk about the importance of cash flow. When you pay too much in taxes, it means your cash flow is lower. As a result you lose all of the opportunities and advantages we talked about in that article. You can’t save as fast, you can’t pay off debt as fast, you can’t invest more, you can’t have that psychological barrier of cash in your account.
When we talk about a culture of living paycheck to paycheck, tax returns are a big part of it. People pay absolutely no attention to their financial picture or spend time fixing it. Rather, they spend all of their money every month and in some cases spend more than they have and rack up credit card balances, or worse, payday loans.
Then comes time for tax returns. People see it as a windfall. Time to go buy something good! This is a down payment on a car, a vacation, a super fancy date night. People think the tax return is free money and just spend it.
But we know better. It is better to know where all of your dollars are going every month. You need to control your money rather than money controlling you. Part of that is keeping it in your accounts rather than in the accounts of the government.
How to Fix It
First note that I am not an accountant or a tax professional in any way. Take my advice as an opinion of a random friend rather than professional tax advice.
2018 is a weird year because taxes are changing quite a bit under the Tax Cut & Job Act. For me, I expect taxes to be lower than 2017 and the same should be true for the majority of readers. You can find a calculator to determine your tax rate under the new plan.
There is this concept called Tax Withholding, and that concept remains the same even in a changing tax climate. Tax Withholding is when your employer takes money out of your paychecks to send to the government. Instead of paying annually, employees pay every paycheck.
Surprisingly, you are allowed to change how much is withheld from your paycheck. Generally you use a W-4 form to do this. I would work with your HR to figure out the best way to fill that out and give it to them this year.
How it works is you find out how many Allowances you will claim. Allowances are a rather complicated thing and their dollar amount depends on what tax bracket you’re in. This is by design, the government is very happy with you sending in way too much money year after year.
You’ll want to find a good solid withholding calculator. I think PayCheckCity’s W-4 generator is a good one to try.
Claim the number of allowances that get you withholding the perfect amount. I would try to leave a buffer of a couple hundred dollars a year so you don’t accidentally have to owe money next tax season, but if you’re saving money up responsibly from your increased cash flow, it should not be an issue if you have to pay a couple hundred during tax season.
I’d say not to be scared about getting the exact correct amount taken out in taxes, just that you get closer to 0 on your next tax return. The challenge here is to increase your monthly cash flow throughout the year!
In these days of low interest rates, I actually don’t think getting a tax refund is all that bad. Back when you could make 5% on interest in a savings account, then it made perfect sense to take the money and put it aside, and end up with a decent amount of interest added at the end of the year. Now that it’s more like 1%, the amount you earn is pretty insignificant, and it might be worth the ‘out of sight, out of mind’ trade-off, where if you don’t see the money, you won’t spend it. Because let’s face it the biggest risk to taking your money now is that you’ll spend some or all of it, and if you do that, you’ve likely negated the benefit of avoiding a tax return.
Money Beagle: I completely agree. The nature of most people is to spend all of the money they have, hence the importance of forced savings.
Unfortunately when those people get their return they’re just going to spend that too.
To those people I’d recommend setting up a new investment account that withdraws automatically from their bank account soon after paycheck time to get the money out of their checking account.
I have a feeling most people who discover this blog are at least going to make an attempt at managing their money well, but the majority of the population certainly behaves as you suggested.