Are You Cheating Yourself From Getting Rich by Making This Common Tax Mistake?

The changing of the year can mean only one of two things for me: We're nearing one of my favorite days of the year, Super Bowl Sunday; and we're also nearing one of my least favorite days of the year, tax day, on April 15.

For some of us, tax time is unwelcome because it necessitates a payment of extra tax dollars to the IRS, or perhaps because of the time it takes simply to complete our taxes. Because I moved and made some larger purchases last year, my taxes will take longer than usual to complete, and I can't say I'm looking forward to it.

Source: Philip Taylor, Flickr.

For other Americans, tax time is welcomed with open arms because the vast majority of people will get money back from the government when they file their taxes. Based on figures from The Wall Street Journal in 2011, of the 143 million people who filed tax returns, more than 80% received money back from the government. While getting money back is always preferential, it could be the worst mistake you'll ever make.

Are you cheating yourself out of getting rich?
If you're wondering why, it's because the money the government sends back to you earns no interest while the government is in possession of it. In other words, you're overpaying your taxes and giving the U.S. government a tax-free loan.

Obviously, there is one positive to overpaying your taxes and getting a refund -- it forces consumers to save. Americans are notoriously poor savers, and anything that would help improve the personal savings rate is usually welcome. According to data at the St. Louis Federal Reserve, the personal savings rate as of November was 4.2%, which is well below the 8% to 12% range that dominated the 1960s through mid-1980s. Low personal savings can be dangerous in times of recession, especially when our economy is so dependent on personal consumption to drive GDP.

Source: St. Louis Federal Reserve.

Despite the benefits of saving by over-taxation, I contend that the damage of forgoing investing this extra income can be far greater.

The flaw of forced savings
Utilizing a Bankrate retirement calculator, I made the following assumptions regarding a fictitious taxpayer, John or Jane Q. Public:

  • Our American taxpayer makes the median average income as of 2011, $51,017.
  • This taxpayer gets back approximately 4% of his or her annual salary at tax time each year.
  • This taxpayer sees his or her annual salary rise 2% annually.
  • The stock market delivers an annual rate of return of 8%.

For our experiment with John or Jane Q. Public, I assumed a starting portfolio balance of $0 and that this individual would work from age 25 to age 65, and then retire.

In this experiment, if our tax over-payer simply collected a refund for 40 years and threw that refund into a savings account (which is currently yielding 1% if you're lucky), he or she would have amassed a bit more than $100,000. Because of inflation, that sum of money isn't going to be enough to retire on by the time the person reaches age 65.

Now let's have a look at our predefined statistics. Instead of overpaying on taxes, John or Jane Q. Public invests his or her projected 4% in annual salary into the stock market each year and comes out around breakeven every year when doing taxes. In this instance, Bankrate calculates that our faux taxpayer would have amassed $692,000 by age 65! In other words, by overpaying your taxes and thinking of a tax refund as nothing more than a way to force yourself to save, our example here would be cheating himself out of more than $500,000 in lifetime earnings! That's substantial!

Here's how you fix this problem
Luckily, there's a fairly easy two-step remedy to this problem that could put you back on track to retiring comfortably.

The first thing you have to do is to align your tax withholding with what you anticipate earning for the year. This doesn't mean you have to hit the nail on the head, but chances are good you have a general idea of what you'll earn in a given year. Plus, you can adjust your withholding rate during the year if your job situation changes and you make more or less money. By estimating your earnings for the year and aligning your withholding status on your W-4 to match that estimation, you'll give up those interest-free big tax refunds and get an opportunity to put your own money to work for you a lot quicker.

The second step feeds off the first step: You need to follow through with your extra income and invest for the long term.

There are a lot of ways of going about doing this, including setting up a stock account with a brokerage firm, participating in a 401(k) or similar retirement plan if offered by your employer, or, most importantly, setting up an individual retirement account that will allow you to take advantage of upfront or back-end tax breaks.

Traditional IRAs and Roth IRAs could offer taxpayers and investors incredible advantages, although you'll have to see (a) if you qualify based on income and (b) which one is right for you. Traditional IRAs allow taxpayers to take an upfront tax deduction based on their annual contribution up to $5,500 in 2013. Eventually, though, you'll pay taxes on your capital gains once you begin taking distributions from your IRA at age 59 1/2. A Roth IRA, on the other hand, has no upfront tax perk whatsoever, but it can really work in favor of younger investors since it does allow your investments to grow completely tax-free as long as you don't take any unauthorized distributions.

So keep in mind as we start the new year and stride into tax season that there are very tangible ways you can improve your financial position ... if you're willing to act on them, that is!

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Read/Post Comments (11) | Recommend This Article (19)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 12, 2014, at 9:23 PM, thedude47 wrote:

    well, unless you have tens of thousands coming back you wouldn't make any interest in a savings account- since banks don't have to pay any these days. the fed has been a disaster for people with modest savings accounts.

  • Report this Comment On January 12, 2014, at 9:49 PM, whoohoo wrote:

    This article is dumb. You are implying that the problem is due to alignment of withholding to represent your estimated taxes, but at the end you compare savings at 1% and investing at 8%!

    If you compared apples to apples (eg, investing at 8%) the difference in alignment and non-aligment is only about $5000 over 30 years.

  • Report this Comment On January 13, 2014, at 12:45 AM, bobisnotafool wrote:

    the government has been artificially propping up the market and desperately needs the people who took their money to put it back in. All this bs like this article. Talking about "missing huge gains". LOL. Ok tell that to people who lost more than half their money in the last meltdown. 270k became 110k. So you take out the 110k, because those"huge gains" would never bring you back to where you were. Maybe up to 180K if you were lucky. However if you had an investment in say. US farmland. You have seen your investment grow regularly at 10-20 percent per year. Last year was the slowest growth in the last 3 decades, a little over 5 percent. Take that 270K put in farmland in 2009 would be 70 percent growth or 189 mil. So you would have a nut of 460K. Or more than twice as much as those savy investors who saw "Huge gains" in the stock market. My family bought farmland at 300 dollars an acre in the mid 1980's. That land is now valued at almost 10k an acre, plus the money made from farming every year. Every year more prime us farmland is lost to development and more cannot be created.

  • Report this Comment On January 13, 2014, at 8:17 AM, GhostdogWarrior wrote:

    Bobisnotafool is right. S0 it foolish to worry about this, as with the war mongering, obamacare, taxes, and getting duped by political lacheys and shills the standard of living will continue to degenerate for 95% of Americans and you will end in the dumper in the end.

    Even 20% returns on that cash of the "new" Walmart employee system wont be enough to pay down the debt you currently owe to the governement.

  • Report this Comment On January 13, 2014, at 9:57 AM, jimantill wrote:

    this is "foolish" in itself. If the average salary is $50,000 plus, then why would you start out at using that number for a 25 year old for 40 years? I think you would be much better using 25 year old average salary and then add 2% a year....that would be much more accurate and is no where near $500,000.00

  • Report this Comment On January 13, 2014, at 10:31 AM, floggerintx wrote:

    Article lost my interest when the author claimed that you were giving the government a tax free loan. The government doesn't pay taxes, we do. The correct statement should have been an interest free loan and these days no one is getting interest.

  • Report this Comment On January 13, 2014, at 1:46 PM, OScammieeyou wrote:

    Obama was never intended to function as it was sold to American public-it is rigged as a spoof phishing scam to gather data otherwise unattainable under Federal H.I.P.A. now snookering the unsuspecting public the weakest and vunerable into opening up once sealed medical files diverted in the process to Obama's own personal use that of which allowed him to issue directives to FDA to fast track approvals for any bio tech companies working on drugs targeting these illnesses in which teh President's blind investment trust takes insider position the efficacy of drugs being tested never at issue as FDA is not a scientific research org. but an political device as past FDA insiders along with bio tech doctors and scientists have been charge with insider trading over the years only that semblance of a cure be made for a quick buck.

    Obama will leave office the wealthiest man on Earth while taxpayers who cant afford insurance fund his exploits.

  • Report this Comment On January 13, 2014, at 2:29 PM, KevinS68 wrote:

    What kind of comparison is this? If someone was going to be smart enough to have a little extra taken out of their paycheck every month and invest it in the stock market, they wouldn't be dumb enough (in a tax refund situation) to put it in a savings account earning 1%. Not to mention that over a 40 year period, interest rates won't stay that low. When I was a kid 30 years ago, banks commonly paid 5-6% interest. You need to compare apples to apples. All an investor loses by getting a tax refund is what they could have earned on that money in one year -- and even then, it's not what they could've earned on the whole amount all year, because they wouldn't get it all up front... rather, they'd get it 1/12th at a time. Sure, in a year like 2013 when the market goes gangbusters, you could've made some money... on a $3,000 refund, assume you had invested it $250/month for 12 months over a period in which the market was up 30%, and you'd have made around 30% of $1500 (the average balance over 12 months), which would be $450. But of course if the markets go down in the given year, you'd be better off getting the tax refund at the end. So it's not like it's easy money.

  • Report this Comment On January 13, 2014, at 4:07 PM, Hman111 wrote:

    If you invest your tax return instead of spending it like most people do, the difference in interest of the avg 6 months is small.

    But I don't withhold more than is legally required. I put a sum in savings in case I have to make a payment at the end of the year.

  • Report this Comment On January 13, 2014, at 6:54 PM, jrosiak2 wrote:

    I'm a retired Accountant. I made a point of over withholding on my paycheck. After we got our annual refund I invested it into a self directed IRA. I had people tell me the same sort of stuff about not giving the government an interest-free loan. Without exception they used their paycheck amounts as they received them in little dabs. Because ours came in a chunk it was invested and not spent.

    We're now retired and have managed to save considerably more than any of those "would-be advisors". They probably were able to do more fun things when they were young but we are much more secure in our retirement.

    BTW, those same people also tended to borrow from their 401k plans so they didn't end up with that for their nest egg.

  • Report this Comment On January 13, 2014, at 8:07 PM, taxpayer007 wrote:

    If the average taxpayer did not "prepay" his taxes in excess of the actual liability each year they would end up borrowing to pay come April 15th. And let's face it, the interest on borrowed money is greater than what would be made by investing the actual refund of which tax is then owed on that income because very few taxpayers would put it in a roth type investment. Most taxpayers would be more apt to spend rather than invest but money never seen is not spent. And refunds are more beneficial to the economy as major purchases are likely to be made with a refund than with the small amount from each paycheck "just another dinner out".

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Sean Williams

A Fool since 2010, and a graduate from UC San Diego with a B.A. in Economics, Sean specializes in the healthcare sector and in investment planning topics. You'll usually find him writing about Obamacare, marijuana, developing drugs, diagnostics, and medical devices, Social Security, taxes, or any number of other macroeconomic issues.

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