Did you know that when you receive a tax refund, it's essentially your own money? That's right. A tax refund is nothing more than a repayment of an interest-free loan that you gave to the government. Very few exceptions apply, including the Earned Income Credit (EIC), Additional Child Tax Credit (ACTC), and the American Opportunity Tax Credit (AOTC). So with that being said, how do you avoid this?
Compound interest is simply money that grows on top of money. A future article will be dedicated solely to this, but it's important to have a fundamental understanding of it when dealing with tax refunds. If you receive a tax refund and the exceptions above don't apply to you, you gave the government an interest-free loan. To avoid this, the first thing you need to do is adjust your W-4 allowances. Virtually everyone is automatically entitled to at least two allowances for federal. State gets a little tricky, but one is the typical minimum amount. How does this impact you? It will give you more money up front that you can either use to invest, save, or pay down high interest-rate loans. Let's go through an example.
You receive a $10,000 tax refund from the government during tax season and none of the exceptions apply to you. There's an investment out there that you know has consistently yielded 10% annual returns for the past ten years. Guess what? You just lost out on $1,000. How? That $10,000 could have been invested in this 10% money making machine throughout the year and you would have earned $1,000 on your money. Instead, the government just might've invested this money and made the 10% on your money without paying you a dime. They simply returned your money (principal) with no interest and called it a day. Now compound (multiply) that by five or even ten years! That's a huge loss. Not to mention, that additional $1,000 can be invested elsewhere to make even more money. So you didn't just lose $1,000, you really lost even more. That's the power of compound interest.
There are a million other ways to maximize your money when it comes to taxes. So a tax refund is not "extra" money. It's merely a repayment of the interest-free loan you gave to the government. Always remember that taxes are all about timing. Either you pay taxes now, later, or never. If you have any questions, please don't hesitate to reach out to me.