A tax refund can be a sweet reward to working hard all year, or so the IRS would like you to think.
The sad truth is that if you are receiving a large refund year after year then you have been giving Uncle Sam atax-free loan.
Rather than continuing to do that, make sure to work with your tax advisor on ways to avoid this "problem" in the future by adjusting your withholdings and/or your estimated taxes.
There are a few different ways to calculate your withholding and estimated tax requirements, so your tax advisor should be able to tell you which method can help you to keep more of your money throughout the year.
For example, if you are on payroll and also need to pay quarterly estimated taxes, you may be able to avoid paying estimated taxes if you can pay yourself a bonus or be able to increase your W-2 withholdings in the last quarter of the year.
In an ideal world, you want to pay just enough of what is required by the end of the year so that you don't get hit with any penalties.
The math is simple. For example, if you usually receive a refund of $2,500 then you can divide that by 12. ($2500/12=$208) So generally, you would want to reduce the amount of taxes you pay each month by this number. The IRS website also has a withholding calculator that is easy to use to calculate by how much to change your withholdings.
It would be much better to have an extra $200 a month vs. getting it at the end of the year, right? If you do find yourself with a large refund coming your way, then be sure to look at some of the "good" and "not so good" ways to spend those tax refund dollars.
Let's look at some "not-so-good" ways you can spend your refund money.
Sometimes when people receive a lump sum of money, they end up blowing it on things like shopping, expensive gifts, or buying other luxury items that may not be needed. Sure, it feels good to suddenly have a large sum of money, but don't start making irrational decisions.
The Luxury Vacationer
If you didn't need to take this vacation, then don't spend all your tax refund money on this without first thinking about your other financial responsibilities for the year.
The Speedy Investor
Don't rush out and invest your money in the next get-rich-quick deal that comes across your table. Even though your tax refund may seem like an unexpected windfall, remember that it was your money to begin with. Rather than pouring it into the first deal you see, make sure that you think through the usual due diligence and only invest if it's an asset that makes sense for you.
Mr. or Mrs. Lotto
Using your refund to stock up on lottery tickets is not a good idea either. I know that as real estate investors we all love the concept of "leverage" and some people may think that they can leverage their refund in lotto tickets and make even more money. But this carries huge risk and the outcome usually is zero return on investment.
Let's now look at some positive ways you can spend your tax refunds that can benefit your financial well-being.
Why not use your tax refunds to improve yourself, your investments, or your business? Sign up for that class you have always wanted to take or buy those business books you have been wanting to read. Educating yourself to improve your real estate business can produce great results for your investments. What's better is that this can even be a great tax deduction for you the next year.
The College Planner
If you have kids or grandkids, using your refund to start or fund a 529 or an Education Savings Plan is a great idea. If you make a habit of always using your refund to do this then before you know it you could save a significant amount of money to fund your kids or grandkids college years.
Think about using your tax refunds to fund a retirement account. It is important to have some sort of a retirement account set up even if you are under the age of 45. With this large sum of money you can easily make a contribution to your future. The best part of retirement funding is that you can actually use your tax refunds to create more tax refunds for next year.
The Smart Banker
Instead of putting your money into your checking account, look at paying down some of your debt with the highest interest rates. After that, put some of the leftover money into your savings or fund your emergency cash fund. You never know when emergencies come up and you need to access that money so use your tax refunds to prepare for those rainy days.
Make your money work for you and grow your investments. Many new investors take advantage of refund time to invest in their very first property. Seasoned investors can use a refund to make any necessary repairs or routine maintenance on their investment properties. Invest wisely to grow those tax saving dollars.
There are many more ideas for how you can use your tax refund in positive ways. Think smarter and do not waste your money. Be sure to speak with your advisor to see how you can change your deductions and keep that extra money each month. If you do receive a refund then think about what you can do with that money to make a better future for you and your family.
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This article is Copyright 2014 BiggerPockets, Inc
Amanda Han of Keystone CPA is a tax strategist who specializes in creating cutting-edge tax saving strategies for real estate investors. As a real estate investor herself, Amanda has an in-depth understanding of the various aspects of investing including taxation, self-directed investing, entity structuring, and money-raising.
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