January 27, 2020, marked the first day of the 2019 tax filing season, and that same day also marks when millions of U.S. taxpayers start thinking about how much they are going to get back from the IRS when they file their tax return.
Will the refund be $1,686, $2,348 or maybe even $4,174?
The bigger the refund the better, right?
Not so fast.
For most Americans, that tax refund has a filing cost attached to it, a cost that can easily top $600.
You may be thinking a tax refund represents money that can and should be used to go on a nice vacation, buy that new flat screen TV, pay down some debt or, best of all, invest. You can do all of those things.
But for the average American, they would be better off financially if they didn’t receive a refund at all.
Your personal income tax refund can be boiled down to a very simple formula, a formula that everybody can understand. Forget about the thousands of pages in the IRS code — that’s what experts are for.
The amount of your tax refund or taxes due when you file your return is based on this formula: income tax – withholding or payments = refund or amount due.
Most of us focus on the first part of this equation: income tax.
We want to and should maximize every single deduction and credit we are allowed to take when filing our tax returns.
It’s the American way.
We have sophisticated software and tax experts we pay to figure this out.
The second part of the equation is just as important. Once the income tax is figured out, the next step is to subtract any withholdings or payments made to the IRS during the year. Withholdings commonly occur when you get paid from your employer, distributions from a retirement account, or receive social security payments.
In most cases, you have the control to dictate and change how much is withheld from these sources during the year. The more you have withheld, the more you subtract from your income tax liability. Also, the more you have withheld, the less discretionary income you have during the year because you’re essentially loaning your money to the government.
Discretionary income gives you the ability to tell your money where to go. Discretionary income allows you to invest, pay off debt or make that big purchase on your terms — not waiting for the IRS to give you the thumbs up.
Take the average American with credit card debt for example. According to Experian, the average credit card debt at the end of each month is $6,040. According to the Federal Reserve’s monthly reporting of APR’s on accounts assessed interest by banks, the average APR for a credit card is 16.86%. That’s right, 16.86%
The average tax refund from the IRS in 2019 was $2,869. The IRS pays a whopping 0% interest to you on this refund.
So now do you see what’s wrong with this picture?
We have $6,040 of credit card debt with an interest rate of nearly 17%, but we’re waiting on money from the IRS, which is paying 0% for borrowing your money.
What if, rather than waiting for your refund at the end of the year, you took control of your money and changed the withholdings to get more in your pay each month, and you use that extra money to pay down your credit card debt, cutting down on the amount of interest you pay.
Let’s just say that you planned perfectly with your withholdings. Rather than getting a refund at the end of the year, you don’t owe anything or get a refund — you break even.
You use the additional $2,869 that you received during the year to pay down credit card debt. That equals $484 of interest you saved by not paying it to the credit card company.
Yes, that is a $484 cost that the average American with credit card debt is incurring by getting their refund at the end of the year.
Add to that amount at least $175 for tax preparation fees and there you have it: $660 is what it costs the average American who receives a refund to file their tax return.
And now for the words that you’ve never heard before in your life: “Don’t worry, the IRS is here to help.”
The IRS provides a free Tax Withholding Estimator for you to use, and this is a great tool to help you determine how much should be withheld during the year.
Use the tool wisely and adjust your withholdings if needed.
• Nate VandenBerg is a licensed tax professional with over 15 years of experience in the tax and financial consulting industry. He is a licensed Certified Public Accountant with an MBA and a master’s degree in taxation.