In 2013, over 50% of all Americans will receive a tax refund. The majority of those receiving a tax refund claim that they will use it to pay off debt. Somehow, we have associated a refund with something positive, while owing taxes is perceived as something you should avoid at all costs. This misconception is entirely wrong and I’ll explain why.
When you begin working for a company, you have to complete a W-4. A section of this form requires you to select a number for federal tax withholding allowances. For some reason, the rule of thumb that everybody uses is to choose the amount of dependants you have as this number…stop doing that!
Changing your withholding will not alter tax rate and the overall amount you pay, it simply changes the amount of tax that the federal government takes from you each time you get paid. If you receive a refund, it’s means that you paid too much money to the IRS during the year and they’re giving that money back to you. It was your money they took and you’re NOT receiving anything extra. Would you let a stranger borrow money from you and pay the exact amount back at the end of the year? I truly hope not.
Notice, that I keep saying “federal” tax – unfortunately, changing your allowances will not affect your state taxes. When paying taxes myself, this is the basis of my strategy. My goal is to pay $0 – 1000 in federal taxes while receiving a state refund of approximately $1000. A state refund is hard to avoid if you own real estate properties due to the mortgage interest and depreciation of the asset. I give myself a little flexibility because there are always some unknowns that I will not be able to account for accurately such as rental repair costs, bonuses from work, etc.
How to use the extra money
Back to what people plan on using their refund money for – paying off debt. I’m assuming most of this debt is made up of credit card debt with an average interest rate of 15%. While you’re paying extra money in taxes each paycheck, your credit card company is charging you to borrow money from them. That makes no sense at all. Increase your allowances and use this extra money to pay down your debt. If you pay off a balance with a 15% interest rate, you are essentially earning 15% on your money!
Many of us have different forms of debt that can always be paid off – mortgages, car loans, student loans, etc. While these loans will have a lower APR than a credit card, it will always be advantageous to pay them down before giving the money to the federal government. Even if you’re lucky enough to have zero debt, you can’t escape inflation. Every day that goes by, your money loses its buying power. To make it easy to compute, let’s say that Uncle Sam borrowed $1200 from you for an entire year. Come December 31, you’re paid back the $1200 with no interest. That same $1200 would have been worth only $1170 at the beginning of the year taking into account a 2.5% inflation rate. Congratulations, you just paid Uncle Sam $30 to use your money for a year.
How to change your allowances
If after reading this, you’re convinced that you should increase your allowances, it is pretty easy to do. If you’re able to go online and view your pay stubs, you can change your election online also. This is a nice feature because it is extremely convenient and you can even change your allowances multiple times throughout the year with not much effort. If you don’t have the option of changing your election online, simply contact your HR department and update your W-4.
If you’re the type of person that doesn’t have much self control and you will increase your allowances, blow the extra money each paycheck while leaving yourself with a tax burden at the end of the year and no cash reserve to pay it, DO NOT change your withholding. Hopefully though, most people are disciplined enough to be responsible with their money and won’t get themselves into a difficult position with the IRS.
Who out there is using this tip already? If not, do you plan on doing so?