Large Tax Return = Epic Fail

The end of January is always an interesting time of year. I hear many of my co-workers and friends explaining how they can’t wait for W-2 from their employer to come in the mail so that they can file their taxes and cash in on a huge return from the IRS. What most of these people fail to realize is that getting a large tax return isn’t a good thing. In reality, it’s the result of a lack of financial planning throughout the year.

Let’s take a moment to analyze how the tax system works for a moment. As we are all aware, a portion of our income must go to the federal and state governments. It’s a fact of life that we all must succumb to. You pay a percentage of your income based on how much money you make throughout the year. In other words, the higher your salary, the higher percentage of your money gets taxed. In order to bring your income down, the government allows you to deduct certain expenses like ones for businesses or, in some cases, education. The idea is that you deduct these expenses from your salary to make it appear as if you made less money to put you into a lower tax bracket to allow you to pay less in taxes. These deductions are what people pay tax professionals to find.

Since it’s nearly impossible to exactly determine how much money a person will make and how much they will be able to deduct, an estimated portion of your income is taken at each payday based on how many allowances you have on your W-4. The W-4 is the form you filled out when you started working for your employer. The more allowances you have, the less your are taxed on your payroll stub. Allowances are given for spouses, dependent children and other situations. The reason large returns exist is because they are taxed more than they actually owe.

This is where many people misunderstand the purpose for this system. Your goal when determining how many allowances you want to claim on your W-4 is to break even. In other words, at the end of the year, you want to owe the government no money, and you don’t want them owing you any money, either. Sounds crazy? If you get a huge return at the end of the year, that means that the government has been holding your money for the past 12 months. In other words, you just gave the IRS an interest-free loan, when you could have been using that money to grow for you.

I challenge each of you as young professionals to stop using the tax system as a savings account that earns you nothing. If you can afford to give the government an extra portion of your paycheck every other week, then you can afford to save it on your own and earn you extra money for yourself. Trust me, the government is making a ton of money off of your money, because they invest it just like any other business. Why not hang onto your own money and put it towards your own financial goals?

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~ by Scott L. Clark on February 7, 2011.

2 Responses to “Large Tax Return = Epic Fail”

  1. Ah, yes, true but the problem is that if you toy with the system too much, you could end up with a hefty bill come tax time. My theory is to play it safe and have the government owe me rather than the other way around. If I could figure out how to break even, that would be great. Any advice on that without risking a bill from Uncle Sam that will really put a wrench in my budget?

    -Caitlin

  2. Very true. Miscalculations could make you end up owing the government instead of the other way around. That said, if you’re saving your money along the way, you’ll have the resources to pay a tax debt at year-end…and would have made interest in the interim. Assuming you were able to save your money without spending it throughout the year, you would be in a better place than if you had loaned your money interest-free.

    As for advice, I’m in no way an accountant that can give good advice. Everyone’s situation is different, and you have to figure out how many allowances will work best for you. If you have a large tax return this year, then add yourself as an allowance and see if you get a bit closer next year. Then throw the extra money you’re NOT paying in taxes in an “out of sight out of mind” savings account in case you over-estimated. With proper planning, you’ll get closer and closer to breaking even each year. You’ll never get exactly even, but it should still be your goal.

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