Myth: The Bigger the Tax Return, the Better

The Word on the Street

Who doesn’t like to get a big fat check in the mail from Uncle Sam every April?

The Truth

When one understands a little bit about how the U.S. tax system works, it can be seen that the closer to $0 your tax return is, the better it is for you.

Doubt me? Let’s take a quick look at the tax system and see why this myth is not true.

What is a tax return, and why do I get it?

A tax return is exactly what it sounds like: they are returning your tax money. But wait, why would the government want to give money back? I thought the government just took and took and took some more! Actually, the government did take and take and take. In fact, they took too much money out of your salary over the year, so now they have to return the excess to you.

How do they know how much to take?

The information you fill out in the W4 form at work is used to estimate of how much you should be taxed for the year. This form can be filled out to either reduce your monthly taxes or to increase them. Generally, you want to try to set it up so that you pay the minimum amount of monthly taxes without paying too little taxes. If you pay too little in taxes over the year, then at tax time Uncle Sam comes a-calling and you have to write the IRS a check for the difference. That’s no fun at all. Consult with your accountant for advice on how to fill out your W4 form properly.

So why should you try for a $0 tax return?

The advantage of a $0 tax return rests in a principle called the time value of money (TVM for short). TVM basically means that a dollar today is worth more than a dollar tomorrow. Let me illustrate:

Let’s say you usually get a tax return of $600. If you could reduce that amount to $0, that would mean that you could have an extra $50 a month that comes to you. If you were to invest this money at a safe 5%, then at the end of the year you would have $614. That’s 14 free dollars every year! And if you were to invest at a higher rate (say you put it into a mutual fund) and earn around 12%, then you would have $640 at the end of the year. That may not seem like much, but over the years it adds up, especially with interest working on it. Say you saved that $50 a month in the stock market for 30 years at 12% interest. After 30 years, you would have $176,500. Compare that to the $144,800 you would have if you invested the $600 once a year. That’s a $30,000 difference, and THAT is significant. That is the time value of money; your tax return money is worth more to you if it comes to you sooner in the year, rather than later.

P.S. This is also a quick way to increase your income for your budget!

Posted on 13 Dec 2007