It’s the beginning of the year, and that means the countdown to tax time has officially begun. I remember, once upon a time before business school, when I got really excited about income tax refunds. The bigger the better. That refund would hit my bank account and, suddenly, I was a baller.
At the foundation of my misappropriated excitement was miseducation. Pre-business school I was not taught about the “time value of money”. Now, post business school, I am frustrated that time value of money is not basic math taught in school. If you were like me and didn’t receive this lesson in school, then here is your time value of money primer along with some added tax lessons.
The Time Value of Money 101
The time value of money is the most fundamental principal in all of finance. This principle states that, since money has the potential to grow by way of interest, money available to you today is worth more than the same amount of money available to you tomorrow. This is the very foundation upon which all wealth is built. In the post “How Much Do Your Spending Habits Cost You Over a Lifetime?” we were using the time value of money to make those calculations. Now we are going to use them again to understand why we do not want an income tax refund.
Example 1: Let’s say that I traditionally receive a $2,500 income tax return. That means that every month I pay the government $208.33 too much for my tax bill. Just imagine if I did that for, say, my cellphone bill. Here you go Verizon, I’m just going to give you extra money every month and you write me a check at the end of the year for anything I’ve over paid. Cool? Thanks. Well, not so much. I already pay those cellphone guys too much, and the same can be said for how much I am paying Uncle Sam. Let’s say that, instead, I put that $208.33 in extra money into a Roth IRA. We are going to assume a 5% interest rate because that’s pretty much what we always assume in calculations on this site because it is a standard rate of return. To make this calculation we can use an extra easy compound interest formula or an even easier online calculator. Enter the figures, hit “show results”, and we see that at the end of the year I have $2,624.96 as opposed to the $2,500 I get in my income tax return. I wouldn’t throw $124.96 out the window if it was given to me. Yet, I do throw that money out the window by overpaying my tax bill every month.
Example 2: Where the time value of money gets really interesting is when you factor in the “compound interest” of time value of money over an extended period of time. That’s where the big money is made. Let’s say I now make a habit of putting $208.33 in my Roth IRA every month until I retire thirty years from now (as opposed to giving it to the government so they can earn interest on it). I will have deposited a total of $75,000 into my Roth IRA account, but I will have given that money value with increased time. Using the same 5% rate or return I can see that I will have a total of $174,399.25 at retirement. That is almost $100,000 in profit that I never have to pay taxes on because of the tax rules of a Roth IRA. This is money I would likely never have saved had I been given that same amount of money as a yearly return. Want to know why? It’s a little thing I like to call:
The Psychology of “Free Money”
Let’s be honest, we spend bulk infusions of cash (what are referred to as “free money”) differently than we spend “earned money”. Even though we earned that income tax money from our paychecks, it is mentally divorced from our work because the check is sent to us from a different source all within one bulk payment. This is why, when I received large income tax returns in the past, I bought stuff I don’t even remember now instead of investing it in my future. Our brains view this as “free money” and it takes a whole bunch of self-restraint to fight the urge to spend it differently than earned money.
There is another bit of psychology at play when it comes to why we feel more comfortable getting a return. It’s based on the fear of the alternative: potentially owing a lump sum come tax time. This can be even more precarious if your income fluctuates month to month. Have no fear. This is why I recommend putting money into a savings fund that does not have a withdrawal penalty. For example, with the Roth IRA you can withdraw any of the dollars you contribute without a penalty. However, you are able to earn interest on those dollars in the meanwhile. See what we did there? We made Uncle Sam’s little no interest loan game work for us.
Adjusting Your Income Tax Withholding
Making adjustments to your income tax withholdings is simple. If you are self employed, then you will make estimated quarterly payments based on last year’s income or whatever your bookkeeper recommends. If you are employed, then you would get a W4 form from your HR department. Then you will want to check out the Intuit 4 step plan for estimating federal withholding. I like this four step plan because it guides you through the W4 including factoring in known deductions and adjustments. The trick to getting the W4 right is to reverse engineer your “dependants” in order to get the withholding to the level that matches your income tax liability for last year. It really doesn’t matter if this is not your true number of dependants as long as you get the withholding right. That whole dependants thing can be pretty misleading.
In the future I plan to give a more detailed lesson on how the compound interest formula works. For now it’s enough to know that it is the foundation upon which dollars saved are turned into wealth. Until next time…happy saving!