For many, tax filing time is a time to look forward to a refund. But you don’t want a refund this year—or any year, but that’s another story. No, you don’t want a refund when interest rates are the highest they’ve been in years. Receiving a refund means you essentially made an interest-free loan to the US government. You don’t want to be the one giving out interest-free loans… you’d rather be the one earning the interest!
Refund means lost money
People tend to think of tax-refunds as “found money,” or money you weren’t necessarily counting on, but then shows up as a nice surprise. But that’s not what a tax refund is; a tax refund is lost money—It’s money you lost throughout the year that you should have made. Many times, the compounding effect of that money could cover a nice meal out, a flight ticket, or an extra night at your favorite hotel. Sometimes, if you’re a high earner, a tax refund could have cost you thousands of dollars in lost earning power.
In today’s interest rate environment you can earn 5% “risk-free” by investing in short-term treasury bills, money market accounts, or a high-yield savings account. So if you end up with a refund of $5,000 at tax time, you essentially “lost out” on earning $250 in interest throughout the year. A $25,000 refund would mean you missed out on $1,250 in lost earnings throughout the year.
In addition to these lost earnings, there’s the practical effect of what an extra few bucks in your pocket would have helped with throughout the year. In an inflationary environment like the one we’ve been in, you’ve needed as much money as possible in your pocket to deal with the high cost of everyday items like groceries and energy bills.
Reasons you may get a refund
A tax refund simply means you overpaid taxes throughout the year. Here are four reasons we see clients getting over-taxed throughout the year, listed in order of most common:
- W4 withholdings are filled out incorrectly
- example: a married person still has their employee filing status as ‘single’ or is not claiming dependents when they should be
- Employer withheld too much tax on stock based compensation like restricted stock units (RSUs)
- Employer’s will typically withhold 20-25% of the proceeds on vested RSUs. But this amount can be higher than the employee’s effective tax rate.
- Withholding on retirement distributions like RMDs is above effective tax rate
- A retiree may be in a 12-18% effective tax bracket but has their RMD set to 20-25% federal tax withholding.
- A business owner over paid estimated taxes throughout the year.
Mistakes on a W4 is the most common reason reason someone gets over-taxed. If you recently married or had kids, make sure you’ve updated your W4 to accurately reflect those events. Remember, if both spouses work, only the highest earning one should claim dependents on their W4.
Get things in order for 2024
Correctly claiming children as dependents is especially important because the child tax-credit is very valuable, providing a fully refundable credit of $2,000 per child. So a married couple who makes less than $400,000, and has 3 children, could be eligible for a $6,000 tax credit. Say that you were taxed correctly throughout the year, but failed to note your dependents on your W4, you could be eligible for a $6,000 refund. But that’s $6,000 more you would have had in your pocket throughout the year, represented by higher take-home pay.
Would you rather have that $6,000 in your pocket throughout the year, via an extra $500 each month? Or have to wait months for your refund to hit? So make sure that W4 is filled out properly! If it had mistakes on them in 2023, don’t repeat those same mistakes heading into 2024. Remember, a refund may feel good when you get it, but it’s actually a sign you were paid less, and earned less, than you deserved to throughout the year.
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