This is the time of year when many taxpayers rejoice. Those are the ones who have just received or are about to receive a refund check from the IRS. For many, it feels like a bonus. After all, in a sense it is “found money” that can be used any way they like. But there is a catch. This “found money” was really your money from the start. Another way to look at it is that you just gave the government an interest-free loan over the past year because you had too much money withheld from your paychecks.
In some cases, the amount we’re talking about is significant. So far, the average tax refund in 2008 totaled more than $2,400. In other words, millions of taxpayers are overpaying $200 in taxes every month (on average) that, instead, they could keep in their pocket throughout the year. For most people, an extra $200 a month would be considered significant cash flow.
A better solution
Some people believe “overpaying” taxes out of each paycheck is a way to force them to save money. But too often, it is easy to find a way to spend the refund check on unplanned purchases.
Instead of giving the government an interest-free loan, you can lower your withholdings on your W-4. You could use the extra $200 a month to pay down debt. Other options include: saving for your retirement in a 401(k), an IRA or an education fund where the money has the opportunity to grow.
For example, people in the 28 percent tax bracket who contribute $200 a month to a traditional 401(k) lower their federal tax bills by $672 dollars per year. Depending on how much you changed your withholding, you may still receive a modest refund even after contributing to your 401(k). Check with your tax adviser to verify your situation. If you contribute $200 into a tax-deferred account earning an eight percent return, after 20 years that account would grow in value to $118,649 before taxes are paid.
Directing the extra dollars into a tax-deferred account such as an IRA or workplace savings plan helps ensure that you won’t simply save the money only to spend it a few months later.
A simple fix
If you find that you are consistently receiving a healthy tax refund every year, it may make sense to revisit the amount withheld from your paycheck. If you decide to adjust your withholding, talk to your company’s human resources department about revising your Form W-4, Employee’s Withholding Allowance Certificate — the official form you were required to fill out when hired to calculate how much federal income tax to withhold. Remember that the calculation has no impact on money that is withheld for Social Security and Medicare. Those amounts are automatically withheld based on a fixed percentage that apply to individuals with wage income from employment.
Instructions for completing your W-4 are fairly easy to follow. Be sure you are comfortable that the adjustments you make will not suddenly result in you owing a large amount of money when you file your next tax return. You will know that the federal tax withholding from your paycheck is well managed if the amount you owe or are refunded every year is $200 or less. A tax preparer can help with this process.
A special bonus for 2008
Beyond the standard tax refund, most individuals with federal income tax liability or at least $3,000 of certain types of income, including wages, Social Security, Veteran’s Benefits, etc. in 2007 are in line to receive a tax “rebate” in the spring or summer of 2008. This is part of the Economic Stimulus Act of 2008 signed into law earlier this year. Rebates will total at least $300 for individuals who qualify to receive it (up to $600 per person, or $1,200 for a married couple filing a joint return) plus an additional $300 per qualifying child.
There are income limits to qualify for the rebate (visit the IRS website at irs.gov for more information). Those who would not normally file a return would need to file with the IRS to get the rebate. The IRS is mailing rebate checks to 130 million qualified taxpayers who completed and filed tax returns for 2007. If you applied for an extension, your rebate will be delayed until your completed return is filed.
This is a one-time rebate (unless Congress approves another plan like it). Therefore, you do not want to adjust your income tax withholding amounts based on the amount you may receive in the rebate program.
Five ways to make the most of your rebate
1. Pay down debts — this “unexpected” income can be used to reduce credit card debt or other loans you may have.
2. Save it for a “rainy day” — put the money in a savings account or money market fund to be ready in case of a financial emergency.
3. Invest it — letting the money grow for several years, for instance, in a mutual fund, could give you the most bang for your rebate buck.
4. Make a purchase to “upgrade” your life — put the money toward a home improvement or similar investment that has lasting value
5. Treat yourself — if you’ve been diligent about managing your finances and saving money, this is a chance to reward yourself with a “fun” purchase or maybe a vacation.
This information is provided for informational purposes only and is intended to be generic in nature and should not be applied or relied upon in any particular situation without the advice of your tax, legal and/or your financial advisor.
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