Recommendations for what to do with your personal finances at income tax time
For a country whose independence move started with a tax revolt, tax time in America typically splits our citizenry into three dominant camps of taxpayers, with only a small but vocal minority complaining about having to pay additional taxes. These three groups include those who have to submit a payment to the IRS at tax time, those who receive a tax refund/credit, and those whose taxes due or tax refund is so small that it is inconsequential.
GROUP 1: The first group tends to be our most vocal. They come from a long line of Americans who detest taxes. Whether they are small business owners who find themselves owing more taxes than expected, whether they started a new, higher paying job the previous year and did not adjust their W-4 accordingly, whether they were on unemployment and elected not to have taxes taken out each week, or perhaps they had a child turn 17 last year, leading to the loss of their child tax credit, this group finds that they owe Uncle Sam and, likely, their state coffers a large income tax payment. Although constituting well over 10 million taxpayers, this group is probably the smallest of the three.
CONSIDERATIONS: You have a couple options to minimize the pain of coming up with a large income tax check in the future. First, and most obvious, is to adjust your W-4 in order to increase the amount of income tax paid with each paycheck. Yes, this means a smaller paycheck, but it also means less pain each payday. Use the IRS Withholding Calculator to figure out what your ideal W-4 might look like. The second option is actually NOT a good option. Some people believe that they can set up their W-4 so that NO income tax is withheld and that they will just pay their entire income tax at once. As the justification goes, it is better to keep the tax in their own account and let it accrue interest until Uncle Same requires it. The problem is that we have a “pay-as-you-go” income tax system, and the IRS wants you to pay taxes with each paycheck. There are exceptions to this rule, but otherwise, you may be penalized if you do not pay as you earn.
GROUP 2: This group includes those who have some well-organized finances or who have submitted a well thought out W-4 to their employer. This group is the least vocal and least animated at this time of year. If, after completing their tax return, they owe some money, it is usually pretty mild. If they are due a refund, it is similarly relatively small.
CONSIDERATIONS: First, stay the course. You have done well to adjust your tax payment to fit your paycheck. Take comfort in two facts: 1) you do not have to come up with a huge tax payment in the spring, and 2) you are maximizing your purchasing power by keeping as much money in your paycheck each month as possible. If we did have another recommendation, it would be similar to the one we share with everyone: make sure that you are paying yourself first with each paycheck. Before you pay bills or make your car payment or go grocery shopping, put money into a savings fund. Otherwise, it will never happen. Plus, if you are among the 40% of Americans who are building their savings funds regularly, come tax time, you will not feel envious of the next group because you will already have something pretty cool in your savings account: a cushion!
GROUP 3: The largest group includes the 8 out of 10 American tax filers who will receive an income tax refund or credit from generous ol’ Uncle Sam. The large majority of households ranging from low-income all the way through households with $200k of annual income get a tax refund. As any CPA worth his or her salt can tell you, the downside to this scenario is that the government is collecting more of your spending money throughout the year, holding onto it, and returning it to you the following spring WITHOUT interest. “So?” you ask. “My savings account earns so little interest that the government might as well hang onto it for me.” This reasoning fails to account for inflation. Averaging around 3.4% annually over the past century (though around 2% over the past decade), inflation eats away at your purchasing power. Consequently, if you allow the government to hold, for example, $100 of income tax for a year, by the time you get it back next year, you will be able to purchase less than 98% of whatever you could have purchased when you earned the money.
That said, given the fact that 60% of Americans contribute nothing regularly to their savings fund, this small loss of purchasing power is a small price to pay for providing 80% of American taxpaying households with a once-a-year savings fund distribution.
CONSIDERATIONS: If you know that you would struggle to contribute to a savings account if you paid fewer taxes and got more money in your paycheck, then it is understandable to look forward to a tax refund each year. That said, we still recommend that you consider adjusting your withholding so that you get more in your paycheck but still have the benefit of receiving a respectable refund next year. Either work with your CPA or check out the IRS Withholding Calculator to figure out the best withholding for your goals.
If, on the other hand, you insist on getting that huge income tax refund every spring, we recommend that you consider using it according to a plan, such as:
• Spend 30% of it on needs (e.g. replacing a broken washing machine)
• Spend 25% of it on paying down debts
• Put 20% of it toward short-term goals (e.g. vacations or an emergency fun)
• Invest 15% of it in your long-term security (e.g. 401k or a future down payment on a home)
• Spend 10% of it on something fun
Regardless of which group you find yourself in this year, it may change next year. Stay aware of how changes in your income or household will affect your income taxes and make an informed decision about whether to withhold more than recommended.
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