By Skyline On Tuesday, April 04 th, 2017 · In , ,

FIELD NOTE: APRIL 2017

THE COST OF A LARGE TAX REFUND

As tax season draws to a close, many taxpayers eagerly await a refund. While a prudent saver might invest those funds, their refund has a downside; if the IRS owes you, you’ve already lost money.

The culprit is your allowances and withholdings. When you were first hired, you filled out a Form W-4, dictating the amount of money your employer withholds from your salary to pay state and federal income tax. The more allowances you claim, the less income will be withheld from your paycheck. Choose too many allowances, and you will owe the IRS money. Alternatively, if you select very few allowances and over-withhold tax, you will receive a refund from the IRS after filing.

With that in mind, why not play it safe, minimize your allowances and receive a larger tax return? The problem is, you are giving the IRS an interest-free loan, while forgoing any investment return.

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To illustrate this, let’s assume that beginning in 2017, your tax refund averages $5,500 annually. In the spring of 2018, after your taxes are filed, you receive your refund and invest the proceeds in a Roth IRA averaging an annual interest rate of 8%. After 30 years of investing your $5,500 tax refund, your account will have grown to $623,058.

Now let’s consider what happens if you had adjusted your withholdings so that instead of receiving a $5,500 refund, you withheld the correct amount. Rather than waiting for spring 2018 to receive your tax return, you can begin investing the difference ($449 monthly) in the Roth IRA starting in January 2017. Assuming an 8% annual rate of return, by the time tax season rolls around in 2018, you’ll have $5,736. That’s $236 more than you would have received with the large tax return. Compound this return for 30 years, and your account grows to $649,739. Simply adjusting your withholdings earned you an additional $26,681!

Paying attention to your allowances and withholdings is an easy opportunity to improve your investment returns without taking additional risk or saving extra money. If you consistently owe or receive more than $1,000 on Tax Day, speak to your financial advisor or tax professional to appropriately adjust your allowances and withholdings.

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