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!
