Ready or not, we're entering the thick of tax season. A little more than a week ago, the Internal Revenue Service began accepting tax returns for the 2019 calendar year, and the expectation is that it'll receive and process upwards of 140 million individual returns this season.
For the IRS, this is business as usual. But for the American taxpayer, it's a bittersweet time of year.
Preparing our taxes stinks, but the reward is often a large federal refund
On the one hand, preparing your taxes, even with the assistance of software, is little fun. Prior to the Tax Cuts and Jobs Act being signed into law in December 2017, the U.S. tax code had surpassed 10 million words in length; the perceived-to-be simplest tax form (Form 1040) came with 105 pages of instructions (just in case you had any desire to tackle tax season without the aid of software); and taxpayers spent an average of 8.9 billion hours annually complying with federal tax laws. In short, the preparation process was, and still arguably is, absolutely miserable.
On the other hand, tax time has sort of become a second holiday season for a majority of taxpayers. For the 2018 calendar year, 101.6 million out of 136.1 million taxpayers who processed returns received a federal refund, as of May 10, 2019. In total, $277.3 billion was paid out to these 101.6 million taxpayers, working out to an average refund of $2,729. This is more or less par for the course over the past decade, with the average federal tax refund ranging between $2,651 (2013) for the low and $3,036 (2009) for the high.
While a lot of taxpayers might view tax time as Christmas 2.0, this mode of thinking is actually all wrong. In fact, I'd go so far as to say that Americans made a $277 billion mistake in 2018. Allow me to explain.
Taxpayers gave the federal government $277 billion in interest-free loans in 2018
Though receiving a federal refund around tax time might sound like a good idea, it's actually indicative of poor planning on the part of taxpayers. In its simplest sense, a tax refund is a roundabout way of saying that you allowed the federal government to pull more out of your paychecks than was needed, thereby giving the federal government access to your money, free of charge. That's right -- while the federal government is holding onto your eventual tax refund, that money is not gaining interest while at the same time losing its purchasing power to inflation.
The fact of the matter is that working Americans are entirely in control of their own destiny when it comes to paying federal taxes on their earned income. Even though the IRS provides employers guidelines on how much should be withheld from a worker's paycheck, every single worker has the right to modify their withholding allowances by making adjustments to Form W-4.
For example, if you continually receive federal tax refunds of, say, $2,000 or more annually, you could choose to adjust your W-4 to have less taken out per paycheck, or completely exempt yourself from federal taxation for a month or longer toward the end of the year. The point is that instead of receiving a lump-sum refund come April of the following year, you'd generate higher paychecks in the current year.
Here's how you're shortchanging yourself by targeting a fat refund
The thing is, you're not only allowing your money to lose purchasing power over time by letting the federal government hold onto your overpayment, but you could be putting that money to much better use.
As an example, a federal tax refund received in April could contain overpayment dollars from as far back as January of the previous year. That means 15 months without earnings that you're rightfully due. If you have revolving credit accounts and carry a balance on these accounts, that extra money could have been used to pare down or eliminate your principal. Instead, by allowing the federal government to hang onto your refund for an extended period of time, you'll be charged more interest on your revolving accounts and potentially allow your principal to build up, possibly making it harder to pay down your existing debt.
Taxpayers would also have a greater opportunity to put their capital to work in terms of building an emergency fund or investing for their future if they properly adjusted their W-4 and aimed for no refund. Having an adequate emergency fund handy could keep taxpayers from high interest charges associated with unexpected bills added to their credit card. Likewise, with the stock market historically returning an average of 7% per year, including dividend reinvestment, waiting even 15 months can prove costly.
The point being that 101.6 million American taxpayers handicapped themselves in 2018. Don't be one of those people moving forward. Adjust your withholding levels and put your money to work on your own terms.