For most of us…
Tax time can be either a stressful event (Wondering if we are going to owe money to the IRS) or a wonderful time that comes with a big annual paycheck! (Large refund)
The good news is that with the amount of information available to us today, it is easy to plug in our numbers into income tax calculators to get a pretty accurate estimate of how much tax we will owe or how much we will receive back.
You have until the tax filing deadline (usually April 15th) to estimate your tax liability. In that time you can reduce the net taxes owed for the previous year. One of the easiest ways to do this is to contribute to a Traditional Individual Retirement Account (IRA) for the previous tax year. You may have to go on your broker’s website and manually submit a contribution for the previous year.
To put the power of this contribution into perspective:
If you are in the 22% tax bracket and you contribute an extra $1,000 into the previous year’s Traditional IRA, then you essentially have sheltered $1,000 of income from taxes and thus lowered your tax bill (or increased your tax return) by $220 ($1,000 x 22% = $220)
Jump Ahead To:
Getting a big tax refund is not always great…
Here is some bad news that could apply to you. While you are working hard the entire year, there are things withheld from your paychecks. These can include: federal income taxes, state income taxes, social security taxes, medicare taxes, Disability insurance, 401k contributions, medical insurance, dental insurance, etc. the list goes on. By the time you get to your net pay (take-home pay), it has been dwindled down to a fraction of your gross pay (before deductions).
Well, when it comes to federal income tax, some amount is withheld from your paycheck by the employer, and the amount withheld from it is determined by what information is filled out on the W-4 (Employee’s withholding allowance). Everyone fills this out when they first start working somewhere, and it should be updated during major life events (Marriage, Divorce, Children). If you get a large refund of your withheld taxes every year, check with your employer to see if you are withholding at the correct amount on your W-4. The amount of withholding is based on how many allowances you claim: 0,1,2,3,4…etc. Most of the time, claiming zero is a big mistake because it withholds the MOST taxes from your pay.
Getting a large refund is not as good as you might think it is because it usually means the government has borrowed money from you all year at an interest rate of 0%. You might have even lost purchasing power in the process due to inflation. You certainly have faced a lot of opportunity cost during the year.
Yes, it might sound exciting to get a large “bonus” once a year, but it is not new money. It is money that you have already earned and should have had working for you this entire time. The opportunity cost of having that money tied up in the federal government’s control is too great for you to be excited when tax time comes.
This is why the most ideal amount of tax to get back during tax time is a low positive amount because it means that you were accurate in withholding the correct amount of taxes owed instead of giving out that interest-free loan to the government. Go forth and adjust your withholding, cut your opportunity cost and make that money work for you all year long!
Recap:
- You can still reduce taxes by the tax filing deadline (usually April 15)
- A big tax refund usually means you gave the government a large interest-free loan
- Adjust your tax withholding using the W-4
- Utilize your money to work for you!