Now that the official tax filing date has passed, most of us usually have one of two mindsets relative to this onerous process. If we’re getting a refund, we’re happily waiting for the check or the direct deposit to hit our bank account. We may have visions of new patio furniture or paying off that high-interest credit card balance. But if we owe taxes, we’re not so happy to have scratched that check to Uncle Sam, our State treasurer or the local tax man. As we dropped that check in the mailbox, we might have been thinking “What does my congressman do all day anyway?” or “Why can’t they repair that massive chuckhole at the end of my street?”
In either case, a question I often get this time of year is whether it is more advantageous to get a refund or to owe taxes when it’s time to file a return.
Like most financial planning questions- there’s a “hard numbers” answer and a subjective answer but let’s run through each scenario.
In the most basic terms, if you’re receiving a refund this year, this means you endured some combination of over withholding from your wages and/or business income this year and/or you paid estimates during the year that exceeded your liability- pretty simple.
So the government owes you your money back. No doubt, getting a check/direct deposit for several thousand dollars always puts a spring in our step this time of year. And I believe this “miscalculation” on the estimate stems from the fact that the tax filing process itself is such a quagmire. The complexity around income tax returns results in a “black box” where we really don’t know with a high degree of certainty how much of a tax liability we’ll actually incur during the year unless we sit down at least once during the year for a detailed tax projection (which I walk through with almost all my clients). This means we “overcorrect” and pay more in taxes throughout the year in anticipation of this “refund”.
But in my opinion, we’re really just fooling ourselves.
As most have probably heard it described, this refund is effectively an interest free loan to the government during the year and I don’t know about you, but lending money to the government is not high on my priority list.
TAX LIABILITY AT FILING
Obviously, the inverse of the refund scenario means your tax liability is higher than the payments you’ve made via withholding and/or estimate payments during the year. Again, the primary reason for this is usually related to the difficulty in navigating the tax code to properly estimate the year-end tax liability.
What some people don’t realize is the federal income tax is a “pay as you go” tax. This means that the onus is on the taxpayer to pay tax on income earned throughout the year – either through direct withholding from your paycheck or by making estimated tax payments. The key is the timing of when you pay the required tax because you can’t just calculate the annual tax owed and write a check on Dec 31st or April 15th.
If you don’t pay enough each quarter, then you may get an unexpected tax bill after filing your tax return for penalty and interest on the underpaid amount. While the calculation (not surprisingly) is somewhat convoluted, the current interest rate on the under-payment amount is 3% and the penalty is 0.5% per month in addition to the interest. In most cases, the penalty and interest probably doesn’t add up to an exorbitant amount, though it could be consequential if you are self-employed or if you receive a large inflow of taxable income without withholding.
In general, the underpayment penalty does not apply if:
- You owe less than $1,000
- You paid at least 90% of the tax owed for the year, or
- You paid at least the same amount of total tax as you paid for the prior tax year – this requirement increases to 110% if your adjusted gross income is more than $150,000 (or $75,000 if married filing separately).
Again, this is where detailed tax planning comes into play well before filing the tax return.
In my opinion, the optimal scenario is to determine proper withholding that is likely to result in a small liability at tax time. This can be accomplished with proper tax planning and a mid-year tax projection that factors in bonus payments, adjustments to portfolios (capital gains & losses) and a myriad of life events impacting a tax return. Of course the primary reason is to keep our money in our own pockets and not rely on the government as a de facto bank. Optimally, your paychecks should be coordinated with tax withholding and integrated with an automatic savings program (direct deposit to YOUR savings account, not the government’s) and a proper liquidity strategy with ample funds to handle any “surprises” when it comes to filing taxes.
As noted above, the risk to incurring tax penalties is relatively minor (especially with a little planning) so it makes much more sense to take this small “risk” of owing some tax in April.
Yes it’s nice get that check/direct deposit in April and yes, it’s easy to think of this as some sort of windfall. But in my mind, I’d much rather look at a savings account statement from April of last year and compare it to April of this year and take heart that I had access to this money when I wanted it – not when Uncle Sam gets around to paying it back.