Tax Refunds: Are they really such a great thing?

It's tax time!! For some, it's a dreadful time, for others, tax time means fat tax refunds are coming in the mail. Before you go celebrating the several thousand dollar tax refund you'll be receiving, you may want to read on, especially if I tell you that taking large tax refunds maybe costing you thousands of dollars. That's right, if you are getting a huge tax refund, you really should be asking yourself why you mismanaged your finances!!

I for one, try to manage my tax refund to be no greater than $500. In fact, if I have some money in some savings accounts, I even try to get it so that I owe the IRS some money at the end of the year! Look at it like this, if you were planning on this, and you factored this into your budget, you were in a sense getting a free loan from the IRS. Obviously, if you owe too much, the IRS can say that you "underestimated" your taxes and make you pay interest. Ever wonder why if you are owed a refund, they don't pay you interest on that amount, but if you are "late" with their money due, you owe them interest!

The reason I started to think about this subject is because in my day job as an Officer Recruiter, I routinely have to process form W-4's for folks. That estimates their withholdings and exemptions so the Navy knows how much Federal Tax to withhold. Almost every single person that comes across my desk puts down 1 or 2 exemptions, stating they are trying to have the maximum withholding taken out of their paycheck. Most of the Officers I know own homes, pay mortgage interest, have kids, and of course, have a significant portion of their paycheck non-taxed (housing allowance, BAS). I had one Officer tell me she routinely gets a refund of $3000 every Spring, her "favorite time of the year."

Being that I am charged with guiding them to a career as a Naval Reservist, my financial advice is kept to myself, but sometimes, I really want to say: "Do you realize you are giving the IRS a tax free loan on YOUR MONEY." Is it laziness? Is it this false perception that money out of sight is money saved? Is it the thrill of getting large checks? Since I was basing my objection to large tax refunds simply out of principle, I decided that I would run some numbers just to see what the financial implications were to having large tax refunds over a period of 5 years. The numbers were amazing!

I used simple financial calculators and of course repeated them on excel to make sure everything was legit. Here is what I found using the previously mentioned scenario of someone getting a $3000 tax refund check every year. I ran two scenarios, both scenarios were responsible people, maintained a positive monthly cash flow, and wanted to save money for retirement, rainy day, whatever the reason. The first person used the lowest number of exemptions to obtain the largest tax refund possible, and immediately invested the $3000 refund, and did so at the end of ever year. The second person took the time to use the IRS withholding calculator and calculated the proper withholding. For this sake, we'll assume that she predicted it perfectly and was left with $0 in refund at the end of the year. She took the $250 that immediately went back to her paycheck every month and invested it. At the end of 5 years, the person who had no tax refund had $710 more dollars than the person who had a large tax refund.

Both people did the right thing, invested the money owed to them. Let's not chastise the person who took the large refund route. At least she saved. But, you can see how starting your investment plan early, in other words, making the IRS give you YOUR money back earlier, allows the interest compounding effect to take over.

No let's get back to reality and some really shocking results. The following example represents a scenario where a family is tight on the budget. In one case, by electing the maximum withholding to be taken out, and by opting to obtain the largest tax refund they can, they are going in the red by $250 every month. To make up for that, they dip into their credit card that charges 12.99% APR. At the end of the year, they wisely use that $3000 to pay down "some" of the balance on the card. (Remember, while you were loaning money "interest-free" to the IRS, you were borrowing money at a cost from your credit card company!!). At the end of 5 years, and after using your 5th year tax refund to pay down your balance, you have a final outstanding credit card balance of $1,715!!

And here is the ultimate kick in the pants. I use these examples because I know people like this, they are just like you and me! The above example "assumes" you use that $3000 to pay down the credit card. But how many people do we know splurge when they receive large amounts of money. It's human nature. After all, we've been struggling all year, we want to be pampered just once this year. Heck, why do you think President Bush is pushing this economic stimulus plan which comes in the form of rebate checks targeted to lower to middle income families. That's because statistics have shown lower to middle income families are the demographic most likely to spend immediate influxes of money. The White House wants us to spend spend spend our way out of this recession. What happens, if one of these years, we fall into that trap, and we spend one of our rebate checks instead of applying it to our current credit card balance (remember, this is the credit card balance started because we underestimated our exemptions). I assume that in year 2, instead of putting the rebate check towards our credit card balance, we used spent it on new home theater system and LCD TV! Our final balance at the end of year 5, even after applying our year 5 refund to our outstanding balance is $6,183!!!

With these numbers, frankly, I find it irresponsible to not take the 30 minutes to an hour each December to determine the proper exemptions to claim for the following year. For military, its almost inexcusable. You could probably do your next year's tax return with 90% accuracy if you did it now. Why, because your military pay is predictable. You know how many kids you have. If you have a mortgage, the interest payments for the most part, are known per the amortization table. At the very least, you should account for the 100% known deductions you know will take. I try not to account for those things that are variable or unpredictable. If I underestimate those and the IRS gives me a refund for those items, not a big deal as long as you were planning your bigger ticket deductions properly.

After compiling a draft of this report, I showed this to a friend who might benefit. It was interesting to hear his response. He understood the implications of lowering his exemptions to get the most amount withheld (therefore a larger tax refund), but stated he did that because it was a way for him to save, plus, he stated, you know the deal, whenever you get more money, you immediately spend it. If that's the case, then "immediately" setup an auto-debit to take that amount out per month. Get your spouse to do it. Or... get your financial planner or tax planner to force you to do it.

My last comment to him before he finally conceded..."You know the 3.5% pay raise you got this year, how would you like it if the Secretary of the Navy said, this year, we're going to hold that 3.5% pay raise until December and pay it out then, because our intention is to hold the entire Navy's pay raise, collect interest on it, and use the proceeds to fatten our budget... what would you think about that?" Well, you can guess what his response was.

Here is the link to the IRS withholding estimation calculator:
IRS Withholding Calculator (FYI: As of 2/3/08, the calculator is unavailable for an unknown reason)

Here is the link to the excel sheet I used to do the "back of the napkin" calculations:
Tax refund Excel worksheet

Free public seminar/webinar, October 20th

My first seminar!! For those that can't make it, we'll be doing a live webinar as well. To register for the webinar, click on this link:
Click here to register for Webinar

Seminar details:
Where: Residence Inn, Norfolk Airport (Tarmac Room)
When: October 20, 2007
Time: 7:00-9:00PM
Address: 1590 N. Military Highway, Norfolk, VA 23502
RSVP for seminar

We'll be talking about home equity management strategy and asset optimization. I've attached a link to the flyer for more details. Please RSVP if you can make it. See you there!

Do you hate your mortgage?!?

I'm guessing a majority of you might have said, "YES!" How about if I told you that mortgages are one of the greatest financial vehicles ever created? Have I gone off the deep end?

Mortgages, plain and simple, allow ordinary citizens like you and me, to acquire assets in the form of homes that normally would have taken us entire lifetimes to save and pay for. Additionally, mortgages allow people to obtain appreciable assets with little to no money down and therefore link the mortgage owner to the gains on that significantly valued asset. Mortgages also provide Americans with their largest itemized tax deduction, allowing many taxpayers the chance to actually use a Schedule A, and surpass the standard deduction.

So WHY ARE MORTGAGES SO UNPOPULAR? Mortgages represent debt. Mortgages represent the largest single expenditure on most budgets. A look at the interest versus principal payments over the term of a typical home loan is enough to make most people sick to their stomach. And in your haste to "rid" yourself of this burden, you pay extra principal payments or get into 15 year loans. And of course, the current sub-prime lending mess has put a bad light on "risky" loans that were once used by savvy investors but have been sold by overzealous mortgage brokers (and even some home builders) to unaware, uneducated, undisciplined, or risky investors/homeowners.

Take a read through the following article which shows that when used properly, and when used as an "income leverage" tool and NOT as a "debt leverage" tool, that mortgages can significantly provide an incredible wealth building mechanism.

My very first business blog!!

Greetings everyone. Wow! My very first blog. Many years ago, I laughed at the idea of blogging. I thought this was merely a way for people to feel more important than they really were by having their ideas displayed for all the world to see.

Now that my blog-savvy friends have passed me by in terms of social connectivity, networking muscle, and online credentials, I too must engage in the art of blogging or go the way of the Internet dodo.

For those that thought they will get the juicy details in my oh so interesting daily life, you are sadly mistaken. I do hope to provide insights, ideas, and perspectives during my first year starting what I believe is the most exciting (and that is taking nothing away from the career I had as a Nuclear Surface Warfare Officer), scary, and stressful path I will have taken thus far.

Stay tuned...