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Written by: Will Holt
Tax efficiency is an important part of building wealth over the long term.
One simple, but often overlooked way to increase tax efficiency is to pay taxes no sooner than they are due. A refund is actually the IRS paying off an interest free loan provided by the taxpayer. There are several different ways that funds can be used more efficiently than letting the IRS hold onto them for a year. Understanding the rules for when and how to pay taxes to avoid penalties is the place to start.
Our tax system is a pay-as-you-go system. Most people pay their taxes through tax withholding’s on a paycheck that are then remitted by the employer to the IRS. Knowing how to claim the appropriate number of allowances on form W-4 should get a taxpayer close to break even when the tax return is filed. Retirees and the self-employed, on the other hand, often pay taxes through quarterly estimated tax payments. There is a schedule for when estimated tax payments are due each quarter and the IRS expects payments to be made in a timely fashion.
The IRS provides a “safe harbor” to avoid underpayment penalties. Understanding the rules may help the taxpayer hold on to cash for longer. To meet the safe harbor test the taxpayer has a choice to either pay 100% (110% for high incomers) of the prior year tax liability, or 90% of the projected current year liability. Most taxpayers use the first rule, but there are situations when it makes a lot of sense to use the second rule. For example, a new retiree may want to use the 90% of the current year’s liability rule because their taxable income in the current year will be much less than when there was a W-2 to claim on the previous year’s return.
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Keeping your money for as long as possible without incurring penalties doesn’t increase tax efficiency unless you do something with it. If you leave the funds in a low interest-bearing bank account all year then you aren’t much better off than if you had gotten the refund. Paying down debt or adding to a portfolio strategy are excellent options. For example, a diversified portfolio with a 60/40 stocks to fixed income allocation likely returned in excess of 10% in 2017. A $1k refund had the potential to earn at least $100 if it had been invested in the diversified strategy. Of course, not every year will have such good returns (there will be some years when the refund would have been better), but consistently executing over the long term will pay off.