Investing your Tax Return

In a previous post, we discussed how to get your tax return for next year in today’s paychecks, and the savings benefits you can accrue as a result of having that money upfront to pay down debt. Today we’ll cover the advanced part of the same lesson – how to use that money each paycheck to increase your tax return.

Following the process previously covered, the average American will have converted a tax return of $3036 for the 2009 tax year, on a per paycheck basis, into $253/month, or $126 for twice a month pay periods, or $116 for biweekly, or $58/week. Going to IRS.gov and publication 15, you can see the withholdings calculations for the various tax tables based on marital status and income levels (shown on about page 39 – it may change as the IRS revises this publication due to new tax laws). This will give you a general idea of the tax bracket you fall into.

Now, looking at the tax table, determine your taxable percentage. For example, let’s say you are in the 25% tax bracket. If you were to take your return of $3036 and put it into a tax sheltered account, like a 401(k) or 403(b), you then reduce your taxable income by that amount. This results in your overpaying your tax liability by that amount times your taxable percentage. So, in the example above, where we have overpaid our taxes this year by $3036, you would take $3036 * 25% = $758. Over the course of the year, we have now saved $3036 for retirement, and still have $758 in our tax return.

If you really want to maximize your investment power, account for the new numbers and do it again. In this case, we have $758 * 25% = $189.50. Repeat it again – $189.50 * 25% = $43.37. Again – $43.37 * .25% = $11.84. While we could give it another go, this gets you close enough to give you a few dollars of leeway if needed.

So, how does this total up? Your original return of $3036 has now turned into:
$3036 + 758 + 189.50 + 43.37 + 11.84 = $4038.71! That’s a nice immediate rate of return of a whopping 33%! If you live in a locality that taxes your income as well, the returns can really add up quickly. For example, a mere 5.75% state income tax like that of Virginia’s will, using the methods above, cause the federal return of $3036 to turn into a 401(k) investment of $4372. That is an immediate 44% return – and an increase of 8.25% in investment over adjusting for federal taxes alone. If you tack on any interest accrued on your investments, this can easily hit a 50% return for the year.

All this is without changing the amount you bring home in each paycheck. That’s  how you build a nest egg.

Saving your Tax Return

It’s that time of year where millions of Americans are eagerly awaiting a check from the IRS. Sadly, many of us waste this money on frivolities they don’t really need. Even worse, a number of us use the return to pay down credit card debt – only to accrue that debt back over the course of the following year. Wake up, America! There are better ways to use that money – yes, even better than paying down debt with your annual refund check.

Instead of waiting all year for the check, get part of it every month. There’s no need to wait – get it now! According to a white house press release (Yahoo, USA Today, FOX) the average household who received a refund thus far was paid $3036 for the 2009 tax year. In other words, on a per paycheck basis, we overpaid our taxes by $253/month, or $126 for twice a month pay periods, or $116 for biweekly, or $58/week!

If, for example, you were going to use that money to pay of credit card debt, making the payments on $3600 of credit card debt at 18% interest until you get next year’s return will cost you about $85/month in minimum payments, and leave you with a debt owed of almost $3200 at the end of a year. Once you use your refund to pay it down, you are left owing $164 (based on the average return number from 2009, of $3036).

In contrast, if you adjusted your withholdings to get your tax refund now (use the withholdings calculator at IRS.gov), in each paycheck, and added that amount to your monthly minimum payment, your credit card would be paid in full within the twelve months – and have $169 in your savings account to boot. That’s a difference of $333 in your favor. On a tax return of $3063, $333 represents a 10.87%rate of return.

That’s a savings anyone can appreciate.

Goal Seeking

Hi, and welcome to the first post of the new blog, Money Matters. It seems to me that when it comes to money matters, there are three basic kinds of people.

  1. The Beggar – “Woe is Me” is the beggar’s motto, and this person endlessly complains about their life while waiting for something good to happen to them. The Beggar would much rather win a million in the lottery at age 80 than earn ten million through hard work and smart investing by age 50. Most families have at least one Beggar among them. Ever hear the you shouldn’t lend money to family? The Beggar is why! A better rule would be to not lend to the Beggar. You may as well light your money afire.
  2. The Saver – “A Bird in the Hand…” My wife falls into this category. Her philosophy with money is that you can’t lose what you don’t risk – and she’s right. Savers are hard working, goal oriented people who are looking for a level of comfort in their financial lives. When I think of Savers, I often conjure up images of the proverbial cash under the mattress (and no, we do not do this if you happen upon our house). Savers also remind me of Depression Era survivors, with a very bleak outlook on non-traditional ways of thinking of money.
  3. The Investor – “Work Smart, not Hard” is the favorite driver of the Investor. Investors are always looking for ways to maximize their earning potential, even if the method is untraditional or risky. Your enterprenuers are investors, though typically their chosen investment is closer to home than most people in this category. Nevertheless, the philosophy is the same. With risk comes rewards.

Which category do you fall in? Hopefully, you are a mix of several. Are you an Investor looking to start your own business? If you don’t have a litle bit of Saver in you, then you are likely to run out of capital before you become profitable in your new venture. It may even send your life spiralling down into the Beggar zone. Are you a Saver looking to retirement? You’re going to need a little bit of the Investor in you if you plan on your money growing faster than inflation eats it away.

Our objective with this blog is to provide you with sound financial advice on how to grow towards your financial objectives as a Saver or an Investor. They say that Beggars can’t be choosers, but Beggars can choose not to be Beggars at all – and if that interests you, stay here in the coming weeks and months for more!