Tis the season to discuss taxes! More specifically, the average taxpayer’s need to do the exact opposite of what they should do regarding tax withholdings and subsequent payment/refund. Since most Americans would rather receive a refund than owe taxes at the time of filing, let’s share some knowledge (math) in the hopes of change. Here goes nothing…
The facts are alarming. About 75% of taxpayers receive a tax refund from the IRS. In 2020, of the 169 million individual tax returns filed, more than 126 million people got money back. More emphatically, you gave the United States government a free loan! I doubt the act of paying taxes appears on anyone’s bucket list, so I am not sure why most people willingly lend money to the IRS. When you receive a tax refund, you have had too much money withheld for taxes.
The problem lies in two areas: 1) Most people don’t know how the tax system works and 2) Give very little thought to the “true loss” when handing over thousands of dollars to the IRS to hold for you for a year.
To simplify, the tax system works as such: 1) On an annual basis, you earn a certain amount of money, and 2) Per the US government, you will pay a % of these earnings as a tax. That’s it. Yes, there are deductions for this and that, but you have to pay a certain amount of income tax based on your taxable income. Where the confusion sets in is how do you pay it? The IRS requires you to withhold a certain amount of your tax liability via your paycheck (i.e., throughout the year). But, they don’t demand you overpay throughout the year resulting in a refund when you file your tax return!
According to the graphic below (from Business Insider), in our great state, the average Californian gets a $2,750 annual refund. By over withholding taxes throughout the year, the average Californian is giving away $116 in investment returns in year one (assuming a 9.5% investment return on the $2,750). That doesn’t sound like much, does it?
If you keep that $116 invested and add the annual $116 to your investment balance, then over 35 years, this little bit of money will grow to over $27,000. Is it time to rethink that free loan you are extending to the United States government yet?
If that doesn’t get you to change your ways, let’s assume you get aggressive and take your free loan away and, dare I say it… owe money with your tax filing!?!? To be conservative, let’s assume that you position your withholdings to leave you with a tax bill of $2,750 in April versus a refund of $2,750. Now you have $5,500 annually to keep invested. Over that same 35 year period, your money will grow to just shy of $55,000. How about that free loan now?
The dollars are different for everyone, so the impact of the free loan varies by person. But, just like you are not going to walk over to your neighbors and hand him $5,500 only to tell him, I’ll be back in a year to collect it, you should not do it with the government. It doesn’t make financial sense!
Happy Tax Filing!
Note: Nothing contained herein in this letter should be considered investment advice, research, or an invitation to buy or sell any securities.