A question that I often ask my clients during counseling sessions is “Do you receive an IRS tax refund check each year?” When clients tell me that they do indeed receive a refund, I ask why they made that choice. Most clients respond that it is better to get a tax refund check than to owe taxes at the end of the year. My advice, however, is different. I think that paying taxes at the end of the year can actually be better than receiving a federal tax refund. The reason is that a “refund” (by definition) is the result of an overpayment. When taxpayers receive a refund, they have overpaid and missed an opportunity to grow their money with interest.
But, of course, there are two sides to every story, and both tax planning strategies have certain advantages. Either way, you should make your taxes work for you. Let’s take a look at both strategies and explore their differences.
Tax Planning Strategy #1 – Owing on Your Taxes
So let’s say you owe money when it’s time to pay your taxes. What are the pros and cons of that strategy?
- If you owe taxes, you have minimized the amount you pay to the government throughout the year.
- The primary benefit of this approach is that you can grow this money in an interest-accruing account.
- Your taxes might be a little more high-maintenance, and since you owe money you will need to be thorough and accurate when filing your tax returns.
- Right now, interest rates are low and savings accounts are yielding very little. This means the gains from this strategy will be limited.
- Don’t get risky. Putting this money in the stock market or in any risky investment can be dangerous, especially if you do not yet know your tax obligation. You don’t want to be low on money in April if you owe a lot in taxes.
Tax Planning Strategy #2 – Waiting on a Federal Tax Refund Check:
Now, let’s imagine that you are getting a refund check. What are the pros and cons this time?
- If you do your taxes correctly and maximize your tax refund, you will have a nice lump sum in the form of a tax refund check.
- This money is like a savings account you have been contributing to all year. Since the government has had the money, you have not been tempted to spend it.
- You are giving the government more money than necessary, taking away your ability to earn interest on that money.
- Getting a big return in the form of a tax refund check is nice, but it will be tempting to use your refund in a financially irresponsible way.
Which Tax Planning Strategy Should You Choose?
We are all different and have different financial habits. Ask yourself these questions when deciding between these two tax planning strategies:
- Do I budget responsibly, track expenses, and have an emergency fund?
- Do I have financial self-control?
- Do I save money regularly?
If you answered “yes” to the questions above, you can probably afford to save your tax money and try to gain interest on it.
Where to Put Tax Money While You Save
I recommend using a different bank or credit union to save the funds so that the temptation isn’t as great to access the funds during the year.
How to Use Your Tax Refund Check
If you aren’t great at saving money, getting a tax refund check could be a financially smart option for you. Think of your refund as a savings account that you have worked toward throughout the course of the year. Since you haven’t had access to the money you also have not been tempted to spend it. When you get the check, try to resist the urge to spend it on a vacation, new appliance, or other expensive item. There are several financially smart ways to use your tax refund. You can establish an emergency fund or even put it toward retirement savings. Whatever you decide to do with your tax refund check, try not to waste it like so many people do.
How to Change Your Tax Withholding
Once you’ve decided on a tax strategy, you need to review your tax withholding. If you want to hang on to your money and think the government is taking too much out, adjust your withholding so that you keep more. If you want to receive a tax refund check as a forced savings account each year, you may need to adjust your withholding so that more will be taken out each pay check. To make a change in your withholding, simply approach your human resources department and ask to adjust the taxes that are being withheld over the year.
Hopefully you now have a good understanding of two basic tax planning strategies. Our expert counselors would love the chance to help you with any other money management questions–you can get started today.