Tax refunds feel like a little extra helping of Christmas, don’t they? Unfortunately, that’s not necessarily a good thing. Let’s discuss what a tax refund actually is and why you might want to make it smaller next year.
Smaller Refund? Are You Crazy?
It sounds outlandish to advise folks to get less of a refund, but that is indeed our goal.
A tax refund is not free money from the government; it’s a literal refund of taxes you’ve paid into the IRS all year long. The larger the refund, the more you overpaid during the year.
The ideal refund, in our hypothetical example, is as close to zero as you can get, because that means that you’ve paid only what you owe. A large refund means you’ve given the federal government a tax-free loan that they pay back without any interest.
Get More for Your Money
Let’s say Emily gets a tax refund of $5,000.
This means Emily has loaned the government $5,000, and the government pays her back at tax time with zero return on her gracious investment. But let’s see what Emily could do with a little strategy.
Let’s go over a couple examples, making the following assumptions:
1) Emily adjusts her W-4 so that she’s paying the IRS exactly what they need;
2) She is paid monthly, recovering ~$416 per pay; and
3) Emily opens a high yield savings account (HYSA) with a fixed 3.8% APY and maintains this rate over 12 months (unlikely, but this is for illustrative purposes only).
Emily invests her $416 per month into this HYSA at 3.80% annual percentage yield. Over this 12-month period, she has $5,079.88 in her account – close to $80 more than the total investment over that period. It isn’t much, but it’s more than the IRS will give for her generosity.
And you can play with this scenario, too. Let’s start the HYSA off with this $5,000 refund from last year’s return and continue to use the strategy above for this tax year. Emily now starts with $5,000 in addition to monthly deposits of $416 into this account. The account has now grown to $10,273.24 – around $273 more than the initial investment!
The main hurdle with making this change is a mental one. It feels really nice to get that lump sum at tax time, and if you’re used to using your tax refund for large household expenses it will take some adjustment to get into this longer-term ROI mentality.
Also, it’s worth noting that your results will vary based on APY and how much you invest.
How to Reduce Your Refund
Your employer takes taxes out of your paycheck to prepay the federal government—this is called withholding, and you can change your withholding easily by filing an updated form W-4. Check with your company’s HR department and they can help you get a new W-4, or you can print the form off the IRS website and bring it to HR to file.
It’s worth the time to check in with your tax professional as well, so they can offer any additional advice to help you determine the correct amount of withholding to reach your financial goals. They may also have referrals for high-yield accounts with favorable rates.
For a complimentary consultation, reach out to us. We’ll happily answer your questions about withholding or other tax concerns.