Can you solve a disagreement?
My girlfriend had a small tax refund last year. She just applied it to next year because she knows she is going to owe taxes. I said she should have taken out the refund and invested it instead. Who is right?
You both are – depending on the circumstances.
When you are owed a tax refund, it typically makes good financial sense on paper to claim it as soon as possible. After all, why would you want to give the government the use of your money without earning interest? And it’s not unlikely that you could generate more money, either in interest or growth, by investing your refund. So in that regard, you’re right.
However, you shouldn’t do tax planning in a vacuum, and context is important. If you know that you’re going to owe taxes, and if you know that you should be making estimated payments, it’s not necessarily a bad idea to simply let the refund “ride” and be applied towards your next year’s tax liability. There’s even a spot for it on your tax return (at least for now):
This can be helpful if you are not good at planning or if you know that you aren’t timely when it comes to making estimated payments. If you owe taxes and you don’t make payments on time, you might be subject to a penalty which could “eat up” any potential growth or income that you could have saved by investing your refund.
(You can find out more on interest rates and refunds here.)
Other factors to consider include the amount of money involved (rolling a small amount over tends to be a better move than a significant amount), your level of financial or investing savvy (this might not be the optimal time to start trading), and your ability to follow through (if you aren’t great at deadlines, making estimated payments can be challenging). Your resources also matter: If you have a financial planner and a tax professional to help you stay on top of things, that can make a difference. Self-discipline is essential, too: If you take the money out with the best of intentions, but end up frittering it away rather than investing it or putting it aside to be used to pay your liability, you aren’t doing yourself any favors.
The bottom line? Know yourself. The Internal Revenue Service (IRS) processes around 150 million individual tax returns each tax season, and each return is different. What works for one person might not necessarily work for another person – even if, as here, you think you know that person pretty well.
Before you go: be sure to read my disclaimer. Remember, I’m a lawyer, and we love disclaimers.
If you have a question, here’s how to “ask the taxgirl.”