Nobody enjoys writing a check to the IRS or state tax authority when filing their annual tax return, but having to do so isn’t necessarily a bad thing. In fact, when viewed from a purely financial perspective, it’s typically a good thing.
First, an over-simplified primer on the US tax process: during each calendar year, a taxpayer generates taxable income (via wages, business income, investment income in brokerage accounts, bank account interest, etc.) and makes tax payments (via employer withholding and/or estimated tax payments). The annual tax filing process reconciles the two, while also factoring in deductions and everything else that determines one’s outstanding tax liability or surplus for the prior year. Upon filing, this liability or surplus is trued up via a tax payment or refund.
Unless we intentionally plan otherwise, many of our clients will owe a payment upon filing, typically because they have substantial investment income that is not withheld upon and/or because their wages are under-withheld upon (especially if a meaningful portion of those wages comes in the form of bonus income[1]). If you wanted to avoid that liability in April, you’d need to “prepay” these taxes by either (1) proactively making estimated tax payments throughout the year, and/or (2) “overshooting” your employer withholding on wage income by enough to offset your taxable investment income and any under-withheld upon wage income.
Not only would either option require additional administrative effort, but they’re also financially sub-optimal. Assuming the liability does not exceed IRS “Safe Harbor” thresholds and reach the point of interest or underpayment penalties[2], the financially optimal strategy is to pay the full balance as late as possible, thereby benefiting from an “interest-free loan from the IRS.” [3]
A tax bill at filing time should be viewed as the repayment of this interest-free loan you enjoyed, while a refund could be viewed as the IRS finally repaying you for the interest-free loan you made to the government. Given the time value of money, the former is preferable to the latter. For those who file on extension, the math is even more compelling.[4]
There may still be reasons to avoid a payment at filing time. For example, if owing a large payment at tax filing would cause significant cash flow issues that couldn’t be planned for, it would likely be better to instead target a smaller payment (or even a refund). Another (non-financial, but still valid) consideration is that some people find it emotionally painful to make a big payment at filing time. People who feel that way might even intentionally target a refund, because they so enjoy the “found money” feeling of receiving one.
In any case, it’s important to know which approach you are targeting and why, and to plan accordingly so that there aren’t any unpleasant surprises upon filing.
Note that this discussion is entirely separate from taking proactive actions to reduce your tax burden itself. There are sensible strategies that nearly everyone should be doing. For our clients, that typically includes maxing out tax-advantaged investment accounts, managing fund placement for tax efficiency, tax loss harvesting aggressively, donating appreciated securities instead of cash, using Donor Advised Funds to “bunch” charitable donations, and other tax-smart strategies.
Even with these proactive strategies, many people will still owe a payment upon filing. If that’s true for you, take comfort knowing that it does not necessarily indicate a “problem,” and in fact is likely the best financial outcome.
Geometric provides tax preparation services through its in-house team of Certified Public Accountants (CPAs). However, this article is for informational purposes only and does not constitute specific tax advice or create a professional engagement. Tax laws are complex and subject to change; please contact your advisor to discuss how these educational concepts apply to your specific tax situation.
[1] Typically, employers will withhold 22% Federal tax on the first $1 million of bonus income and 37% on any bonus income greater than $1 million. If a client is in a marginal tax bracket above 22%, then there is a gap between the tax liability generated by the first $1 million of bonus income and the associated tax withheld.
[2] Tax liabilities up to a certain threshold are penalty-free (generally, you will not owe a penalty if each quarter you have paid in the lesser of 90% of current year or 110% of prior year tax); states may have different thresholds. Below that threshold, a penalty is applied to the outstanding balance for the period of time covering the date when the tax liability was due until the date when the payment was made.
[3] To be more precise, the financially optimal approach would be to plan to owe tax payments up to the projected breakeven point where the projected interest exceeds the projected opportunity cost, with the opportunity cost being the expected return of those dollars being saved/invested over that time period. This tends to be too precise a goal to target, so we typically just aim to avoid interest and penalties.
[4] While most taxpayers file their returns by the annual deadline of April 15th following the tax year, some instead file an extension that allows them to file their returns as late as October 15th. Many of Geometric’s clients file extended returns because they receive business income (often from private investments) reported on K-1 forms that are not produced until after the April 15th deadline. For these clients, we still complete the reconciliation process before April 15th (estimating any K-1 income that is still unknown) to determine if they have a liability or refund. If they have a liability, we ensure that they make the payment when filing the extension (rather than waiting until they file the return later in the year) because a liability of any amount incurs interest starting on April 15th. If they have a projected refund, they won’t receive it until they file their extended return, which prolongs the “interest free loan to the IRS.” Thus, for those who file on extension, there is an even stronger argument for preferring a payment to a refund at tax time.