Many look forward to getting a tax refund every year. It can feel great to have a sudden influx of cash from the government that you can use to pay off some debt, save toward a goal, invest, or even just buy something fun for yourself. However, if you’re getting a large tax refund every year, that’s actually a sign that you could benefit from better tax planning.
What Is a Tax Refund?
A tax refund is essentially the government paying you back a zero-interest loan that you gave to the government. It’s not bonus money that you get for free, even if it may feel like it. It’s the amount that you overpaid in taxes that the government borrowed from you all year until they give it back, with no interest, to you during the next year’s tax season.
While an influx of extra money come tax season may feel great, it actually means that you could be planning your taxes better.
Why You Shouldn’t Want a Tax Refund
If you’re getting a tax refund or owe a lot every year, you should check your withholdings. If you’re paying too much, you can reduce the amount that you’re withholding so that you’re paying a more accurate amount. You won’t get a tax refund later, but that money can be working for you, earning interest or getting invested rather than sitting with the government interest-free. You should also make sure that you’re not withholding too little, either, because that could trigger a fine from the IRS.
How Much You Pay in Taxes Is More Important
Whether you get a refund or owe money when you file taxes actually has nothing to do with how much you owe overall. The refund or payment you owe is just the difference between what you were supposed to pay in taxes and what you actually paid. For your overall financial health, it’s a better idea to forget about how much of a refund you might get and focus on reducing the total amount you owe in taxes instead.
Fortunately, there are several ways you might be able to reduce the amount of taxes you owe overall.
Look for Tax Deductions
The first thing you should do is look for possible tax deductions that you might qualify for. For example, charitable donations might be tax-deductible up to a certain amount. Student loan payments may also be tax-deductible. Look for tax deductions that sum up to a number larger than the standard deduction that applies to everyone. Talk to your financial advisor to make sure that you aren’t missing out on tax savings. Some common tax deductions may include:
- Home office purchases
- Interest payments on a mortgage
- Interest payments on a student loan
- Charitable donations
- Real estate taxes
- Tax-loss harvesting
What Is Tax-Loss Harvesting?
Tax loss harvesting is an investment strategy that seeks to offset capital gains tax by selling certain investments at a loss. This is done because capital gains are taxed at a higher rate when they’re short-term than when they’re long-term. It may feel like you’re losing money, but that’s not the case. Tax loss harvesting is a strategic way to reduce the total amount you owe in taxes and can save you money in the long run.
Check for Tax Credits
A tax credit can be even better for your finances than a tax deduction because it can ultimately save you more money on taxes. Check with your financial advisor to see if you qualify for tax credits for any of the following reasons:
- You have children
- You’ve purchased an electric or hybrid vehicle
- You’re paying for higher education
- You make too little money
We do not recommend you do any of the above (i.e. have children or buy an electric car) just to save on taxes. Ultimately the cost of the above usually outweighs the tax savings. But if you have already done so, perhaps for other reasons such as helping the environment or the fulfillment of a larger family, there might be savings available to you.
Put Money in Tax-Advantaged Savings Accounts
Another way to possibly save money on taxes is to make contributions into savings or investment accounts that are tax-advantaged. Some examples of tax-advantaged accounts include 401(k) and IRA retirement accounts, as well as HSA accounts.
Roth vs. Traditional 401(k)/IRA Retirement Accounts
Both Roth and traditional 401(k) and IRA retirement accounts are tax-advantaged, just in different ways. With a traditional retirement account, your contributions are tax-deductible no, but then you would owe taxes when you began to withdraw funds from the account. On the other hand, Roth retirement accounts are taxed when you contribute to the account but are tax-free upon withdrawal. Talk to your financial advisor to determine which option is best for you.
What Is an HSA?
An HSA is a health savings account that can be extremely advantageous when it comes to tax deductions. HSA contributions are usually 100% tax-deductible. On top of that, taxes are deferred, and distributions are tax-free so long as you spend the money in the account on qualified healthcare-related expenses.
Talk to Your Financial Advisor
Unless you’re a financial expert yourself, the absolute best thing you can do to reduce your taxes is to talk to your financial advisor. They may be aware of deductions and credits that you didn’t know about and can help you with investment strategies like tax-loss harvesting.
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