Why Your Big Tax Refund Is Like Flushing Money Down The Toilet

Every year between January and April it seems everyone gets excited about a big tax refund they expect to receive. This has always baffled me. Is it because I don’t like money? Or maybe it’s because I don’t like to see other people have money. The real reason is because tax refunds are interest free loans made to the government and wouldn’t that money be better off in your pocket?

The average tax refund for 2009 was $3,036, which means tax payers could have had an extra $253 a month if they had proper tax planning. Some people may not think this is a big deal, but let’s look at how much money we would have if we invested that money each month. At the end of each month we invest the $253 into a Roth IRA which will grow tax free. At the end of year one, we’ll have $4,801, or an extra $1,765. If we continue this over a ten year period, you would have $32,421,928! Seriously. Now, if you waited until the end of the year to get your $3,036 tax refund and then invested that at the same rate as above for ten years, you would only have $43,981.

I realize that this scenario might seem ridiculous because our tax situations change and we may not be able to invest all of the money each month for ten or more years. But don’t you want to try? You could be a multimillionaire in just ten years!

I said in the title to this post that a big tax refund is like flushing money down the toilet. The money down the toilet is the interest not being earned. A very simple solution to this is to fill out a new W-4 at work and change the number of allowances. This form has instructions that can walk you through how many allowances you should claim (the more you claim, the less money taken out of your paycheck), but often times you will still get a big refund at the end of the year because the calculations don’t take into account tax credits and deductions. The best bet is to consult a tax professional who can help save you the most amount of money by planning for every available credit and deduction.

Here is the other big reason I hear why people love their big refunds: “It’s a forced saving plan which keeps me from spending it on things I don’t need”. As I’ve shown above, it’s not a very good savings plan. And let’s all be honest for a second, how much of our refund goes into savings? We all want that money to go into savings, but most of it ends up in the hands of retailers. This is why I advise people to automatically invest part of their paycheck in their Roth IRA or other savings vehicle. You’ll never see that money and therefore won’t miss it, and if you put it into your Roth, it will grow tax free. I’ll tell you why a Roth IRA is so great in a later post.

So after reading this, I want you to go into work tomorrow and fill out a new W-4 and see if you can’t lower how much tax is taken out of your paycheck. Just compare how many allowances you currently have with what the new W-4 calculates (to find how many allowances you currently have just look at your current paycheck). More importantly, talk to a tax professional who will be able to help lower your yearend tax liability and save you even more.

Being Laid Off: The unthinkable happened

I hear everyday how the economy is getting better and because the GDP has officially reached positive territory we've moved out of the Great Recession. This is great news unless you were just laid off. And I was just laid off.

After years of hard work and putting my wife through lonely late nights and weekends while I bartended, I finally started my accounting career. And in a field that is supposed to be recession proof, there was no worries about me being laid off. So we purchased a house, had central air and a brand new garage door installed, and did a small kitchen remodel.

And then I get laid off for lack of work.

So many thoughts immediately run through my head, but one of the loudest is screaming, "Is my house going to get foreclosed upon after only one mortgage payment!?". After crunching the numbers we will be able to survive.

Only hours after being laid off I started contacting members of my network and received two solid leads. If one of these two positions turns into a job, I might actually turn on a profit on this stretch of unemployment. That's because I was paid all my vacation time as well as severance until the end of the month (vacation time actually covers the first half of July). So if I am lucky enough to start working before then, I'll end up making money (but I'll be happy just to get a job!).

Should my unemployment continue beyond July 15, the financial cutbacks would have to officially begin. Even with the emergency fund we have, I would probably have to put both of my private student loans into forbearance, which means the interest would keep accruing and I would have the option of paying it off each month or capitalizing it. This decision and whether or not to pay it off is a topic for another day.

At this point, I am extremely optimistic of my chances of landing a job before months end so I'll leave you with this thought: No one is safe from cutbacks or layoffs so everyone needs a six month emergency fund in case the unthinkable happens to you. In times of deep recession it should even be 9-12 months. Each month represents total monthly expenses without having to cutback on your accustomed lifestyle. It's never too early to start saving for an emergency, whether unemployment, medical, or natural disaster, that most of us will find ourselves in at some time in our lives.

Public vs. Private School

I live in an area where everyone seems to be alumni of a private high school. As someone who grew up in an area that was just the opposite this is alarming to me. I have always heard that private school was very expensive and I always wondered if children’s’ privatized brains were much smarter. I have a one year old daughter and want her to grow into the brightest, smartest girl possible, so should I be thinking about saving for her education?

Let’s take a look at how private schools match up to public schools.

Cost

The average annual tuition of a private high school education is $8,549 according to the National Center for Education Statistics. This includes both religious and nonsectarian schools. This means a privately funded high school education costs almost $35,000! Now here is the kicker: Since public education is funded primarily through property taxes, you’re also paying a full tuition to public school.

You may be screaming that it’s worth it, that the high cost will equate to a better college which will lead to a better job which will lead to curing cancer! Maybe it will, but since no one has yet to cure cancer, do you really want to sacrifice your financial future to find out?

Public schools educate 88% of the children in America, 2% are home schooled, and I would like to argue that there is no way that the other 10% who attend private school are the only ones growing up to become doctors and lawyers and CEO’s. And let’s remember, public schools are free! The only cost is from taxes which you pay anyways.

Education

You may still be saying private schools are worth it because public education is dismal at best. This may be true in many parts of the country so a closer look at each jurisdiction is needed to make the decision of whether or not to pay for private education. For example, the county where I grew up is one of the wealthiest in the country and yet almost everyone attended public school. This is because the wealth paid for a premier public education system, whereas if you live in a very poor area there is no money to pay for schooling. So assuming all things being equal that private schools do not educate children any better or worse than public schools, we find a catch 22: If my jurisdiction is wealthy and pays for a great schooling system, why pay for private school? And if I live in a poor area then how could I possibly afford a private education? Here is a statistic that reiterates my point: 80% of children who come from families with annual incomes of $100,000 or more attend public schools.

But how about standardized scoring comparing the two schools? Do private schools score better on these tests? On the SAT’s, private school students score an average of 75 points better than public school students. One explanation is that private schools have more access to SAT prep courses. Anyone who has ever taken the SAT’s knows that it isn’t entirely about how smart we are. The other explanation is that private school children are smarter, but I think 75 points falls into the test taking ability category.

External Factors

A few days ago my wife and I were talking about whether or not private school was worth the cost and a couple of factors were mentioned that might outweigh both cost and education: religious aspect and safety (safety from drugs, the “wrong crowds”, violence, etc...). In 2008 81% of private school students attended a religiously-affiliated school. For the extreme cost savings, why can’t parents just send their kids to Sunday school like my parents did?

The other reason why parents wish to send their kids to private school is to protect them from the evils of public school lifestyle. Depending on the area you live, your neighborhoods may be violent, drug laden black holes that suck children away forever into gangs and jail and cemeteries. Of course that is one extreme, but what if that’s where you live? I bet those public schools aren’t very successful. If I lived there I would sacrifice everything to send my child to a private school to get away and have a chance at a better life. So ultimately there is much more to think about than just dollar cost and quality of education.

Financial Gains

At this point, assume for a second that the decision is based solely on dollar cost. As I mentioned earlier, the average cost of a private school is $8,549 per year, or almost $35,000 for high school. Now what if you took that $8,549 and invested it each year earning an average 8% return? After four years you would have close to $50,000. That’s an impressive gain in such a short amount of time. For most of us that would equal a one year emergency fund which, over the past couple of years, we’ve all learned how important it is to have given current economic conditions. Now think about how much it would cost to send your child to 12 years of private school vs. how much you would have if you invested it. The numbers are staggering.

Conclusion

As I said before, there are many factors to consider when deciding on public vs. private schooling such as cost, quality of education, and religious aspect. Some will be more important than others but at the end of the day, I urge everyone to also think about what is financially sound for the family and consider the consequences of paying such a high price for education.

-- If you like what you read and want to learn more about personal finances, become a follower of this blog and recommend to your friends and family on Facebook by clicking below.

How Our Children Can Save Us Taxes

Have you ever wanted to reduce the amount of tax you owe to the government? I certainly wish I didn’t have to pay any taxes, but the reality is that most of us are making enough money where we do have to pay taxes. Although the IRS will always try and get a piece of our income, there will always be ways to hide it from them. Today I want to share a few of the ways that those of us who have children, or will have children in the near future, can benefit from using our children to help lower our tax bills.

The first way our children can help us save taxes is by transferring investments into their name. The IRS allows children under 18 to have unearned income up to $950 without having to pay any taxes. The next $950 will only be taxed at the lowest tax rate, which is 10%. Anything over this threshold will be taxed at the parents’ rate, which can be 15% - 35%. Unearned income is usually from interest and dividends, but can be anything where you don’t actually “work” for the money. So the goal here is to transfer up to $1,900 into your child’s name. That can be as much as $570 in tax savings, and having your children report income (even at your higher rate) can produce other tax savings. Most of the tax credits and deductions that exist have income limits, so the lower we can get our income, the more credits/deductions we are eligible for.

A perfect example of this is from a family friend who has student loans. Up to $2,500 of student loan interest can be deducted from income if your modified adjusted gross income (MAGI) is below $70,000 ($145,000 married filing jointly). Their MAGI was $148,000 and they couldn’t take the deduction. If they had $3,000 transferred into their daughters’ name, they would have qualified for the deduction and ended up saving $39 in tax. And they might have even qualified for other deductions or credits to save even more money.

Another great way to save on taxes is to hire your children in the family business. Your goal here is to have wages paid to the children reduce the business’ income and therefore reduce the tax owed. This does of course have to be legitimate. You have to own a business and the child has to do actual work, so this probably wouldn’t work with a very young child (unless you own a modeling agency) but it is perfect for teenagers.

For the working parents among us, many employers offer reimbursement accounts for such things as child care and health savings. These accounts allow the employee to deposit parts of their paycheck tax free and then be reimbursed. What’s nice about these accounts is that your taxable income is lower and therefore less tax needs to be withheld from each paycheck. Here is how it works in relation to my family. My wife elects to have a daycare expense account through her employer and chooses to have the maximum withheld over the course of the year, which is $5,000. Each paycheck she receives will have approximately $192 taken out and placed in the account, tax free. When she submits her receipt for paying our daycare, she is reimbursed for that expense. The tax savings lies in the fact that at the end of the year she has $5,000 less in taxable income, which will save us about $1,250 in tax.

Reimbursement accounts are a great way to reduce your income tax if you are spending the money anyways. We already pay to have our kids in daycare and most kids, depending on their age, are seeing the doctor many times a year. These costs can all be paid into a reimbursement account. As mentioned above, a health spending account works exactly the same way, only the expenses are for health related goods and services (i.e. prescriptions, doctor visits, over the counter drugs, etc...). Since there are certain rules and restrictions it is important to talk to a tax professional to see how you can get the most savings come tax time.

Now, since the summer officially kicks off this Memorial Day weekend, I want to mention how we can deduct summer camp expense on our taxes. We already know we can deduct child care expenses, but did you know summer camps can be included? As long as your child is under the age of 13, attends a day camp, and the camp is to allow parents to work, then this expense can also be deducted as a child care expense. Paying for camp never seemed so fun!

There are other ways to reduce your tax liability through your children and these are just the most overlooked in my opinion. Taking a few minutes out of your day to set up one of these scenarios for yourself will save you a great deal over the years.

-- If you like what you read and want to learn more about personal finances, become a follower of this blog and recommend to your friends and family on Facebook by clicking below.

Welcome to The Financial Liberator

Welcome to The Financial Liberator, a financial blog for those of us who want simple and easy to understand advice about our finances.

I am a public accountant who specializes in individual and small business taxation, bookkeeping, and financial planning. In January 2012 I will officially become licensed as a Certified Public Accountant in CT, and am already working towards my Personal Financial Services certificate. I have a wife, a 17 month old daughter and have just purchased my first house, and with all of this happening in the past two years, it wouldn't come as a surprise to hear that I've lost control of my finances (and my sanity!).

But I haven't. And the reason is because my wife and I have a budget and a plan. And we stick to it. Plain and simple.

From here on out I will be focusing on how my family handles the day to day pressures that a toddler and a brand new house (to us; the house itself is 50 years old) has on our wallet. I will also be talking about the various ways to save for your future, including college, retirement, and vacations.

I encourage an active conversation so we can hear many different viewpoints and maybe we can all learn something new. So please ask any and all questions.