How do I pursue every angle financially? A one- or two-minute video is great, but it hardly allows for details. How can I not overpay my taxes and still get an influx of cash at tax time?
The IRS withholding calculator is a fantastic resource for this. Simply use your previous years tax return, enter the data, and the IRS will estimate for you what your withholding/exemptions should be to maximize your monthly paycheck and minimize your tax refund, while avoiding owing money. This is theoretical, and if your income is significantly different from the previous year, or you receive a new increase such as a bonus in the current year, you will not be able to use your previous years tax return. Your tax professional or financial advisor can help with this calculation.
The withholding calculator, however, does not help you with that once a year windfall. To still attain this setup an automatic payroll deduction, or allotment, from your paycheck into a separate account. When you file your tax return each year withdraw the money from your separate account and you have your “tax refund” plus a little bit of interest/earnings!
There are many types of accounts you can utilize with varying advantages and disadvantages Here are a few options:
1) Basic Savings
Advantage: It is available at anytime without penalty (assuming a $0 minimum balance) and highly secure.
Disadvantage: It is available at anytime without penalty and as a VERY low interest rate.
2) 1-year CD
Advantage: It is restricted for a year so that you cannot withdraw the money without a penalty. This restriction is a “guardrail” to help keep you from spending your “tax refund” before tax time.
Disadvantage: The interest is going to be REALLY low. A 1 year CD is not that much more than a basic savings account in total return. You are sacrificing total return for security. Essentially a 1-year CD is valuable for the guardrail, more than for the return.
3) Brokerage Account
Advantage: It is really liquid most of the time. Regarding stock purchases, there are stocks that are difficult to sell, however, generally stocks are easy to sell and therefore relatively liquid. In addition, since you can invest in the market the likely return is much higher than any account you can use at a bank.
Disadvantage: It is the market so you have no fixed rate of return, meaning you might lose money. If you are in a position where you cannot handle the loss of your “tax refund,” investing this money in the stock market is probably not for you. In this case leave the stock market for your retirement account investing only for now.
4) Roth IRA
Advantage: This form of investment has very similar advantages to a brokerage account with one notable exception: Your growth (Interest, earnings) is tax-free! Additionally, with a Roth IRA you can withdraw contributions penalty-free. Each each around tax-time you can withdraw your “tax refund” and let your earning keep growing tax-free!
Disadvantage: Once again, similar to a brokerage account, you can lose money so if you go this route, and cannot take a big risk of loss, you may want to consider a bank Roth IRA rather than a brokerage Roth IRA. A bank IRA as a fixed rate of return, so while it will not be a very high return, it will be more than a basic savings account, and the risk of loss is essentially gone. Another disadvantage is that the earnings/interest cannot be withdrawn without penalty until age 59.5. However, this is a minimal disadvantage, after all the alternative is overpaying your taxes and getting a refund from the government which includes ZERO interest!
You may think that this will take a lot of work, and the setup certainly will take some effort. However, once setup it will flow easy and require minimal attention once a year when you file your tax return. When you start thinking creatively, honestly, and ethically to pursue every angle with your finances, it will usually require a little additional effort. The idea is that this extra effort will gradually produce additional income creating passive income. Passive income is income you make without having to work day in and day out.
Other examples of passive income include:
Rental Income from real estate
Dividends from stock ownership
Interest from bonds and savings accounts
As you can see taking advantage of every dollar earned, as soon as legally possibly, can add up quickly over time. In fact, the absolute ideal for paying taxes is paying nothing every month instead paying an estimated quarterly tax. This allows you to use much more of your money much sooner. For most simply paying the proper amount of taxes each month will be a good balance allowing you to pursue more honest angles while keeping things simple.