Why a Large Tax Return is a Big Mistake
As tax time approaches and thoughts of big tax returns coming in soon are getting people excited, I thought I’d take some time to tell you why a bigger tax return is actually a bad thing and how proper planning can help you be most efficient with your finances.
First let’s walk through what a tax return actually is. When you earn money the government withholds a portion from your paycheck. However, it doesn’t know what your current year’s tax bill will ultimately be. Sometimes the government takes too much out and at the end of the tax year they give the excess back to you (without paying any interest on the money you basically loaned them throughout the year).
Why is this bad? From a mathematical perspective it’s bad because of a concept called time value of money. Which states: a dollar in the future is worth less than a dollar today. The reason this is true is because of compound interest, the sooner you can invest your money and start earning interest the more time that money has to compound and the sooner it can be worth more. Let’s look at a specific example.
Let’s take two different situations, Jill & Tom starting at age 25 and retiring at age 65. Jill does extensive tax planning and does not have a big tax return after she files but is able to save an extra $375 per month by paying the proper amount throughout the year. Tom on the other hand doesn’t plan around taxes and gets $4,500 back in the form of a tax return after filing. This equates to the same amount of money they have to invest but because of the timing of investments, end in different results. If both were to invest that money, let’s see the results assuming this went on for 40 years (obviously this could not be an exact real world example but it keeps the math simple and illustrates my point). If they both get 8% returns per year for 40 years here is how the final amounts shake out.
Jill: $1,309,127
Tom: $1,165,754
A difference of $143,373 at retirement. As you can see, the math alone would make the case that this is something you should strive to get right every year. However, in real world practices I think the real ending amounts would shake out something more like this:
Jill: $1,309,127
Tom: $0
This is because of the behavior of the average person surrounding unexpected large sums of money received otherwise known as financial windfalls. In the real world what do most people do with their tax returns? They blow it! New clothes they wanted, trips they wanted to take, blowing it at the casino. All typically happen when presented with a large unexpected sum of money. Having consistent cash flows throughout the year makes it much easier to invest and could result in more money in your pocket.
In conclusion, it is difficult to pay taxes correctly throughout the year and requires working with a great financial planner. Prepaying your taxes the wrong way could result in heavy fines and fees assessed by the IRS. If you are not prepared to take the time and put in the energy, it won’t be completely detrimental to have your taxes withheld and receive a tax return each year, after all Tom still ended up with $1.1 million at retirement (provided he didn’t blow his returns!). What really matters is that you have a plan for every dollar to make sure you’re making the most out of your money to achieve your goals. Working with a financial planner can help with that! From giving you options surrounding how to save and invest every available dollar to keeping you accountable and focused on long term goals, working with a financial professional gives you the confidence that you’re exactly on track to get to where you want to go.
If you’re interested in starting the financial planning process and setting yourself up for success, reach out!
Will
Securities and advisory services offered through LPL Financial, a registered investment advisor, Member FINRA/SIPC.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.