Tax Bill or Tax Refund - Which is Better?
Every year at tax time, there are a couple of typical responses from tax filers. Either, “Yay, I get a big, fat check!” or “Oh, man, I have to write a big, fat check!”
Either way, you’re just settling the account with Uncle Sam. Each year, you owe a certain total amount of taxes. Your taxes are actually due on a pay-as-you-earn basis. So you pay them out of your business income or W-2 employer income throughout the year. If you pay too much throughout the year, you get money back. If you don’t pay enough, you owe money (and also, in some cases, a penalty).
So is it better to owe the IRS money or to get a tax refund? Well, that’s a discussion worth having. Each option has its pros and cons. Here, we’ll discuss the pros and cons of each, as well as how you can get your tax refund or taxes owed as close to $0 as possible.
Pros and Cons of Owing on Taxes
Writing a big check to the IRS–or even a small one–doesn’t sound like fun. But there are actually upsides to this option. When you owe taxes, though, you also have to pay a penalty. As long as you settle up in full when you file your taxes, the penalty is minimal. It’s basically paying the IRS interest because it didn’t get to use your money for the rest of the year.
But even with that penalty, owing taxes could be a better situation for you than getting a tax refund. Here are some pros and cons to consider:
- You haven’t paid the government too much through the year. When you owe taxes, you know the government hasn’t had free use of your money for a good chunk of the year.
- Instead, you can earn interest. If you can invest your money to earn interest–more interest than the penalty the IRS charges–you’ll come out on top with this strategy. Alternatively, you could use some of the money to pay off high-interest debt, which is essentially the same thing.
- You have to be ready to write that check. The taxes owed penalty from the IRS isn’t huge. But if you have to put your taxes owed on a payment plan, the penalties can seriously add up. So it’s best to keep that money in savings so that you’re ready to write a check when you file your taxes the next year.
- You could lose or spend the money. This is linked to the above. If you use the money you should have saved for taxes or put it into a risky investment, you could be unprepared to write the IRS a big check at the end of the year.
- Interest rates are still pretty low. You may not be able to find a stable investment where you can out-earn the IRS’s fees right now. Even with interest rates on the rise, they’re still very low for savings accounts, so you’ll have limited gains from this strategy.
- You really are supposed to pay taxes throughout the year. Paying absolutely no taxes during the year may not be a great strategy. You might try to under-estimate your taxes, but legally, you’re supposed to pay them as you earn them.
How to Do It Well
With this strategy, you just want to under-estimate the amount you should be paying in taxes. If you’re running a side gig, for instance, you can pay a small percentage of your earnings quarterly to the IRS, but don’t go all the way up to the 25% or more you could ultimately owe. Or you can take an extra deduction on your W-9 for your employer. This will bump up your paycheck because you’ll pay the IRS less money.
The goal here isn’t necessary to pay all your taxes in a lump sum at the year’s end. But you can hold back some money to ensure you aren’t over-paying. Just be sure you keep the money someplace safe, like a certificate of deposit that will mature when you need to pay your taxes or a money market account. This will net you some interest earnings without running the risk that you can’t pay your obligations at the end of the year.
Pros and Cons of Getting a Tax Refund
Getting a tax refund seems like fun. It’s a big check that you feel like is “free.” But that money really should have been in your checking account earlier in the year, to be useful for paying off debt, buying things you need, or investing. Here are some pros and cons to getting a tax refund:
- It’s a forced savings vehicle. Many people intentionally over-pay on their taxes throughout the year as a sort of forced savings. You give too much to the IRS out of each paycheck. You barely notice it coming out, but at the end of the year, you get it all back. If you’re terrible at being a disciplined saver, this can be one way to get started.
- It comes out incrementally through the year. Since the money comes out little by little through the year, the refund can be a nice surprise. A few bucks a paycheck may not seem like much, but multiplied by twelve months, it can turn into a nice little nest egg.
- You can use the money well. If you’re like most taxpayers who regularly get a refund, you probably have a plan for the money. Since it comes in a lump sum, it can be easier to make a solid plan to use the money well. If you use it to pay off debt, sock away savings, or meet another big financial goal, you’re using it well. If that money came in with each paycheck, you might have just frittered it away, instead.
- You don’t earn interest on that money. A hundred dollars per month over the course of the year is $1,200 no matter how you slice it. But if you pay that money to the IRS, they earn interest on it by putting it to use. You do not. If you’d saved that money in a high-interest account all year, you’d have a bit more than if you wait until the IRS pays it back to you (without giving you any interest, I might add!). And if you’re carrying high-interest debt, paying off that debt would make your money go even further over the course of the year.
- It doesn’t build good savings habits. As a forced savings vehicle, over-paying on your taxes seems great. But it doesn’t really build good financial habits and that discipline you need to be a truly good saver. You’ll never save for your whole retirement with this strategy, for example. And you may need to practice physically transferring money to your savings account as a discipline to really build this skill.
How to Do it Well
If you’re struggling to save money or pay off extra debt right now, planning for a tax refund can be a good stepping stone to more financial discipline. But you really should try to estimate your taxes paid so that you aren’t getting a huge refund each year. Instead, shoot for a few hundred dollars that you can save when you file your taxes.
In some cases, such as with the Earned Income Tax Credit, it’s impossible not to get a refund. With this credit, you’re getting money in a refund that you didn’t actually pay to the government. So if you’re in this bracket, don’t worry about getting a hefty refund each year! Just use that money wisely so that you can better your financial situation year by year.
Getting or Giving Close to $0
Ultimately, if you’re a disciplined saver, the ideal tax situation is to get your refund or taxes owed to as close to $0 as possible. Some years, this will be difficult. Maybe you have a baby near the end of the year, or you change jobs and get an income boost. Any major change in your financial situation can make it difficult to estimate your taxes. But the goal should be to get everything as even as possible.
That way, you can save or spend your own money throughout the year, and you don’t have to pay the IRS penalties on top of the taxes you owe when you file. You can use the IRS’s calculator tool to try to figure out what you should pay in estimated taxes throughout the year here.
Sometimes, it’s okay to strategically under-pay or over-pay on your taxes. But your goal should be to get to the place where you don’t have to do either because you’re making great day-to-day and overall financial decisions.
Making decisions regarding taxes is not an easy task. So instead of working hard and wasting time, your better get yourself a subscription with online tax software. Using an online tax prep software will save you a lot of time and effort. You will also be able to consult with a tax expert regarding any decision you will have to take.
If you would like to learn more about how to navigate your taxes, check out the informative course offered by Cofield’s Concepts.