Over the past 35 years, I have prepared, reviewed, and filed thousands of income tax returns for a vast array of clients. Some of the clients earn millions of dollars each year while others are just starting out. Something common among all of them, besides filing a tax return every year, is the need for managing their tax payments. The question I’m often asked is whether a client should overpay their taxes at least a little so they get a refund, or should they pay the least amount possible so the government doesn’t get their money any earlier than required?
The fact is, nobody likes paying taxes. Even those who profess that paying taxes is their patriotic duty would gladly give up that duty if they could get the same services at a lower cost.
Most of us simply admit that one of our goals is to legally pay the least amount of taxes possible. In fact, that is the topic of my book, Tax-Free Wealth. How can you legally pay the least amount of taxes possible?
Simple Cash Management
While tax-free wealth is a legitimate goal for investors and entrepreneurs, most people still end up paying some taxes while they develop and implement their strategies for legally eliminating their taxes. One of the biggest challenges is managing the payment of taxes.
From a purely mathematical standpoint, it never makes sense to pay in more than you have to, even for a short period of time. After all, you could at least make a small return on the money if you kept it in your own bank account instead of giving it to the government to sit in their bank account. So most accountants (who live for math) tell you that you should pay the least amount possible during the year and then pay whatever extra you owe on April 15.
I’m not convinced this is the best answer for everyone. In fact, most people would probably be better off managing their tax payments so they get a little refund on April 15; some people may even want to increase their payments. The reason is simple cash management. Very few of us are good at managing our cash flow. We tend to live from one moment to the next, never setting aside money for the future.
This difficulty with setting aside money for future expenses is likely the primary reason for the big 401(k) industry. From a tax standpoint, 401(k) contributions make no sense. You are shifting taxes from years in which your tax rates are likely to be the lowest because of your business, employment, education, and family-related tax benefits to years in which your tax rates are likely to be the highest—unless, of course, you are planning to retire poor, in which case you will be in a lower tax bracket when you start pulling money out of your retirement accounts. In addition, you are shifting income from low-taxed income—dividends and capital gains— to high taxed income—retirement income. By giving people a tax deduction now and sometimes an employer matching contribution (which also doesn’t really do much for you as discussed in the book, 401(k)aos by Andy Tanner), people are encouraged to set aside at least some money for the future.
Paid Up By Tax Day
How about just setting aside money for the next April 15? I could tell you hundreds of stories about people who have decided not to pay their taxes during the year and then got caught on April 15 with a big tax bill that they could not pay because they spent the money instead of setting it aside. The biggest culprits are not the middle-income or low-income earners as you might think. Instead, they are entrepreneurs who believe that they will always make more money, so why not spend what they have?
A better alternative is to manage your cash flow, especially your tax payments, so you are fully paid in by April 15 and maybe even have some left over. You can take the left over amount— the overpayment—and either use it for some necessary improvements to your house, take that well-deserved vacation, or apply the refund to next year’s taxes so you don’t have to take so much out next year.
What is the best way to manage your tax payments? That’s simple. All you need to do is call your tax advisor four times a year to see how you are doing tax-wise and make sure that you are paying the right amount. If your income primarily comes from your job, you can increase or decrease your withholding. If your income primarily comes from your business or investments, you can increase or decrease your quarterly payments.
The other advantage of doing this, of course, is that every time you meet with your tax advisor, you and he/she are likely to come up with ideas for reducing your taxes. Your situation changes regularly and so do your opportunities for tax reduction. As I like to say, if you want to change your tax, then you just have to change your facts. Meeting with your tax advisor regularly not only avoids ugly surprises on
April 15, it also multiplies your opportunities for changing your facts to reduce your tax.
Pick What’s Right For You
So look at your situation including how you feel about paying taxes on April 15 versus getting a refund. If you are good at managing your cash flow and hate giving the government your money even one day before you have to, then go ahead and set up your payments so you pay the least amount possible during the year without having to pay a penalty. On the other hand, if you enjoy getting money back from the government to put towards your dream vacation or your next big purchase, manage your tax payments so you always get a refund. After all, the word “fun” is right in the middle of the word, “refund.”