Episode 3: Getting a Refund Does Not Mean You’ve Won

Benjamin Brandt: All right. Welcome back to the Retirement Tax Podcast. I’m your humble host as always Benjamin Brandt. Joining me as always is the illustrious Steven Jarvis. How you doing today, Steven?

Steven Jarvis: I’m doing really good. I’m feeling pretty good about being illustrious. I think that’s a new adjective for me.

Benjamin Brandt: Steven, I have a tax question for you.

Steven Jarvis: Please.

Benjamin Brandt: What is the perfect tax refund?

Steven Jarvis: The perfect tax refund. Well, it’s kind of a personal question, Ben. Like everyone, that’s something that everyone kind of has to decide for themselves. For me, it’s that I do get a refund, I hate making payments. But that it’s less than a thousand dollars.

Benjamin Brandt: So, you’d say maybe there’s no right answer. When I work with clients, there’s a variety of right answers. And I think that is the right answer. It is that there’s no right answer. I’ve got clients that are so… Their relationship with the IRS is such in a way that they don’t want to pay in any money until they absolutely have to. And then there’s some clients that have… They have certain bills, their house, real estate taxes, or there’s some insurance premium. They’ll like to get a couple thousand dollars in March or April of the year. And after 15 years of being an advisor, I really don’t think there’s a right way. There’s wrong ways, paying in way too much and getting way too much back is probably wrong. But I don’t know if there’s the right refund. It’s probably like a dollar, right?

Steven Jarvis: Yeah. I guess in a perfect world, you would get it to zero every year that you wouldn’t make a… And you could do that in theory, you could get to the end of your tax return and make no payment and have no refund. That would be, I guess, the perfect situation. But the amount of time and energy it would take to do that, it wouldn’t be worth the return. So, I like what you said there, that there really isn’t a single right answer, but there definitely are wrong answers.

Benjamin Brandt: Yeah. I think about the effort that it would take when I work with clients at the end of the year to work on tax projections. The effort it would take to get it exactly right. And then the teeny tiny things that could go wrong to make that right number wrong again. We underestimated the interest that your checking account paid. Not that they paid any interest anymore anyways, or, or there was a capital gain distribution that just sort of came out of left field and we missed it. Getting that amount down to the penny, I think it’s just probably more effort than it’s worth. So I think having a comfort zone of 1,000 one way or a 1,000 the other is probably right. So let’s talk a little bit about if we agree on the right answer is whatever your preference is. Let’s talk a little bit about what the wrong answers might look like. When can we really get in trouble with either getting too large of a refund or paying in too much at the end of the year?

Steven Jarvis: Yeah. Well, let’s start with getting too big of a refund. You’re not getting in trouble with the IRS at least. The IRS is going to send that money back to you.

Benjamin Brandt: And a thank you—

Steven Jarvis: Yeah. Quick side note on that. I mean, right now there’s a huge backlog with the IRS in getting refunds. There’s a lot of headlines about that, but just so everyone knows those backlogs are for people who submitted paper returns or are asking for checks in the mail. If you submit electronically, if you request electronic refund from the IRS, those get processed within weeks. So just a good reminder to be doing as much as we can electronically. But as far as getting too big of a refund, I actually have a personal experience with this. And I just have to point out that this was right as I was finishing school really before I started my career, because this is mildly embarrassing as a CPA to have to admit to this.

But I had a year where I got an $8,000 tax refund. And when I first finished my taxes and saw and that’s what I to get, I was ecstatic. I thought I had won like literally in my head. I’m like, I just beat the IRS because I’m getting an $8,000 tax refund. And then all the things I had been learning started kicking in. I was like, oh, wait a second. No, getting an $8,000 tax refund means I did something really wrong this year, because all that is, is an interest free loan to the IRS. That means I had them withhold way too much for my paycheck or from a distribution, or I made too much in estimated payments, whatever the case might be. And the year that that happened, I was in school for part of the year. So I still qualified for a lot of education credits.

And I only worked for part of the year. So my income wasn’t that high. And I just had my first kid and there was all these things that contributed to that being the case. But if I would’ve even looked just once or twice during the year to say, okay, what are my withholdings versus what am I really going to end up paying? I could have had that cash a lot sooner in my life. And as a freshly graduated student with a new baby living in a new town, I could have used that cash flow a lot earlier in my year.

Benjamin Brandt: Sure. And especially in retirement planning, right. Cash flow is the name of the game. So if you get an $8,000 refund, Hey, it’s like $700 give or take per month that you could have been living large and making memories. So, getting a big refund, you really want to be as intentional as you can. I guess that’s the sort of the overlap of every really that I can think of financial planning and retirement planning topic. But that intentionality really does pay off if we can make it happen. I’ve got a somewhat similar story. I’m happy to share it because it makes me look good. But I had a client that we helped to buy a house and she had to take a significant amount out of her IRA.

And it happened to be a before 59 and a half distribution. So huge tax implication and an early distribution penalty. And the next time we were visiting, she was pleased as punch that she got a tax refund. Of course, doesn’t sort of recognize the huge tax bill that she paid that was probably close to six figures, but she was extremely happy that she got a tax refund. Now, the reason I did it that way is because I knew that she was tax sensitive to this topic. So I over withheld and I probably over withheld too much, but she was happy. And I think that’s the right answer at the end of the day, right? If you’re doing financial planning for someone else for a fee, the customer’s always right, right?

Steven Jarvis: Yeah. And so as we look at this and we’ll circle back in a minute to how we can get in trouble on the having to pay too much into the year, because the IRS isn’t as forgiving on that side. But part of this is a mindset. We want to make sure that we are intentional, that we have a goal in mind and that we’re working toward accomplish that goal as far as how much our refund is. For me, it’s that less than a thousand dollars. I’m not going to use the IRS as a forced savings account. I want to make sure I don’t have to pay them at the end of the year, but less than a thousand dollars, isn’t going to make me feel bad that I let them have some of my money. So it’s the combination of having a goal on that side and then understanding how much of our money the IRS kept regardless of how big of a refund we get.

Because that’s where we’re going to start having better perspective on why it’s so important to do these different things, to kind of sand off the rough edges of our retirement tax bill. Because if all we focus on is, Hey, I get a refund every year. Even if you’re just… You’ve got it dialed in and I get a $500 refund every year, so super I’ve won. Again, that’s not the right attitude. Because if we look a little bit higher on the 1040, instead of focusing just on the refund or payment and look up to on this last year’s 1040, it was line 24, which was your total tax. That’s really what the IRS is keeping. And you can have your refund really dialed in and getting money back from the IRS and they could be keeping 30, 40, 50, $60,000 of your money. But if like this example, you’re sharing, if all your focus is on is how great is it that I got to refund? You’re not going to have the context for why it’s important to think proactively.

Benjamin Brandt: That’s interesting. I had not thought of it in exactly that way, but if you get too large of a refund that could be signaling that the refund is covering maybe potential deductions or other tax savings that potentially that you missed. If you get a $5,000 refund and you don’t look at anything… Any deeper into that, well maybe it could have been an $8,000 refund, right? If we’re sort of peeling back the curtain and, and examining some of those issues underneath.

Steven Jarvis: Yeah. So for me, those almost are two different conversations of how much do you want to get as a refund each year? Or how much would you like to pay at the end of the year? And I’m going to work with clients to make sure we don’t have any underpayment penalties if they want to make a payment at the end of the year, but that’s one piece of it. And really I try to separate out the other piece of make sure you understand how much tax the IRS keeps each year, because especially if that refund gets to be a large number, it can be easy to get distracted and think, oh, well I get this big refund. I’m good. I don’t need to talk to a professional. I don’t need to spend more time on this myself, but that refund really just gives us no indication of how we’re doing with making sure we’re only paying the IRS what we absolutely owe and not leaving them some extra tip.

Benjamin Brandt: Well, could we talk a little bit about what’s what some of that extra tip might be. Like, what if we owe too much at the end of the year? What are some of those kind of magic numbers that we should look out for?

Steven Jarvis: Yeah. So if we’re talking about having to make a payment at the end of the year, that’s fine. The IRS certainly allows for that as a potential way for this to happen, but we’ve got to make sure that we’re not making a payment that’s going to subject us to what the IRS calls underpayment penalties. Because the IRS wants their money and they want it by specific dates. And a lot of us just think of the tax deadline as April 15th, when really that’s the tax filing deadline. The tax payment deadline actually comes earlier. In fact, the IRS has multiple deadlines throughout the year that we have to make estimated payments by or have withholdings by.

And then ultimately for 2021, the tax payment deadline is January 18th just because the 15th happens to be on a weekend. And so if we haven’t paid enough of either our current year tax bill or our prior year tax bill of what the IRS call safe harbor rules, the IRS will start charging us penalties and then they’ll start charging us interest if we take too long. And so we’ve got to make sure that we’re being proactive in how we do this. That’s probably the worst way to leave the IRS a tip. Sometimes when we talk about leaving the IRS a tip, we’re talking about not taking advantage of certain opportunities, but probably the worst way to leave them a tip is to pay those penalties.

Benjamin Brandt: Okay. And so those numbers are based on prior years?

Steven Jarvis: So there’s a couple of different ways that the IRS looks at it. The easiest one to remember is that if you owe less than a $1,000 come tax time, then you’re under that safe harbor and they’re not going to charge you a penalty. Then there’s also a safe harbor based on the total tax you owe in the current year. So this isn’t whether you get a refund or make a payment, but if I owe a total of $10,000 in tax this year, if I’ve paid at least 90% of it, or $9,000 in this case by the tax payment deadline, that I’m under the safe harbor rules. And maybe 10,000, isn’t the best example because that would still be under that $1,000. But if I owe a $100,000 in taxes, as long as I’ve paid, at least 90,000 of that by the deadline then I’m not going to get charged a penalty. Another way that safe harbor can come into play is if I’ve paid a 100% of my prior year tax liability.

And this is really good in years where income has gone up significantly. So if my income doubled this year, Hooray for me. Maybe I didn’t expect it or didn’t plan ahead for it correctly and I hadn’t had enough withheld. The IRS will let you fall under safe harbor if you’ve still paid a 100% of what you owed last year. Now, if you’re in certain income brackets, you get into a little bit higher income, it does have to be 110% of the prior year, but it can be either of those. It doesn’t have to be both.

Benjamin Brandt: Okay. So, if your income went way up this year. Maybe you got laid off due to COVID last year, but you’re back in the saddle this year and you paid in 30,000 in total income tax last year, if your income is over 150,000, you want to pay in at least 33,000 to make sure that you will avoid some of those penalties?

Steven Jarvis: Yeah, that’s correct. Now, you’re still going to have to pay all the tax you owe at some point, but those are just those safe harbor provisions so that we don’t have penalties if we’ve waited until the end of the year to make those payments.

Benjamin Brandt: Okay. So we are talking to an audience that is either retired or rapidly approaching retirement. What if you find yourself, sort of, let’s say September, October, getting towards the end of the year and you evaluate your last year’s taxes and you realize that not you’re not quite where you think you should be. Are there any year end tips to get a little bit extra to the IRS? Could we take a distribution out of our IRA and do something unique with that or?

Steven Jarvis: Yeah, so typically there’s two ways we can pay the IRS. We can have them… Or we can elect to have tax payments withheld from our wages or distribution, or we can make estimated payments. Now the IRS ends up with the same amount of money either way, but they don’t actually treat those the same. So a withholding is always treated as if it happened evenly throughout the year. Which is really powerful for this situation that you’re talking about. If we get towards the end of the year, and we’ve realized that we owe the IRS a significant amount of money, but we haven’t been making estimated payments during the year. If we go ahead and make an estimated payment, the IRS will say, well, wait a second. You actually owed us money throughout the year and you still might get under payment penalties.

But on December 31st, we could have a withholding from an IRA distribution, for example. And the IRS would treat it as though it happened evenly throughout the year. Now I would recommend you don’t wait until the absolute last day of the year. I always like to leave a little bit of time to make sure that administratively we’ve gotten everything done. But yeah, having withholding from distribution is a great way to make up any deficit in taxes we owe, just because of that treatment from the IRS.

Benjamin Brandt: Well, that’s kind of a funny little trick, right? If you, let’s say you owe $20,000 at the end of the year, option one would be take 20,000 out of my IRA, write a check if people still possess checks and then send that in to the IRS. But that could actually be financially a worse situation than the easier thing, which is just contact your custodian, take a distribution, do a 100% tax withholding and have that go. And that’ll be seen as received equally throughout the year. Now our custodian funnily enough, doesn’t let us do a 100%. We have to do 99 and one which is strange, maybe every custodian is like that. We only have the one, but I always thought that was a… So client will get $100 from a distribution. The rest will go to the IRS, but that always struck me as kind of quirky but-

Steven Jarvis: Yeah, something you want to double check because I can’t speak for every custodian, but I have heard of multiple situations like that. So just one of those nuances to understand so you’re not surprised by it.

Benjamin Brandt: Interesting. Nuances is interesting. The IRS is known for nuance, right?

Steven Jarvis: Nuance is probably the nicest word we can put to it. They have known for lots of things. So Ben you brought up, looking at your taxes in September, October and seeing where you’re at related to the end of the year. And something to keep in mind when you’re doing that, or maybe prompt you to do it earlier in the year is if you’re having any big changes in your life that might have those big fluctuations from one year to the next. So if it’s the year that you retire or if there’s a change in your filing status, or if you have significant one time income, either this year or last year. Because what can happen is when we have a year where we have significant one time income and our total tax goes up a lot this year, for example, now next year our safe harbor is a lot higher than it’s been in previous years.

And so when we have these big fluctuations, it’s just something to double check. Since there’s a safe harbor, both based on the current year and the prior year, you’re still have a pretty good chance that you’ll be okay, but it doesn’t take that long to double check. It doesn’t take that long to say, okay, how much income do I have so far, we can find an easy tax estimator online. There’s plenty of amount there now to say, okay, what am I projected to owe? But just to do that quick double check, because at least for me personally, seeing those IRS penalties, even when it’s on a client’s return, that’s one of those things that is like, man, we could have avoided that.

Benjamin Brandt: That’s that IRS tip, it’s somewhat avoidable. The only thing worse than paying taxes is paying an avoidable tax, right?

Steven Jarvis: Yeah. Completely agree. Yeah. There’s nothing quite like having to explain to someone that, oh, not only do you have to pay more in taxes, but some of that’s a penalty. Some of that is not even in your tax bracket. It’s not something you had to have paid. You could have easily avoided that.

Benjamin Brandt: Well, Steven, let’s say that listener listen to this show and they wanted to take some action and they went back and calculated their total withholding for the year. And for whatever reason, they found that they have over withheld by quite a bit. I’m trying to think of what would be a good use for those funds. So if you found that you’ve over withheld, what popped into my mind is maybe we could then have money ahead on like a Roth conversion or something like that. Maybe we can accelerate some income to match that extra withholding. Have you run across an instance like that where we’re able to sort of redeploy in advance that extra refund that now we realize maybe we don’t want such a big refund.

Steven Jarvis: That’s a really interesting idea. Typically I try really hard to work with clients on kind of dialing that refund end or if they are going to have a big refund it’s for a specific purpose, but that’d be a great use of it. Because the alternative is you either proactively think of what’s another strategy that I can just leverage this money I’ve already sent to the IRS. Or if we’re identifying this several months or a few months before the end of the year. We can change our withholdings towards the end of the year and just not have as much withheld to get that back in line.

Benjamin Brandt: Or just drop them off completely too. Skip the last two months of withholding if you’ve realized you’ve withheld way too much and extra money at Christmas time.

Steven Jarvis: Yeah, exactly. The one thing I would really encourage in that situation is that if you’re going to change your withholdings like that, make sure you have a system in place to remind yourself to change them back in the next year. Anything we do, it’s good to have systems, reminders, use calendars, things like that. That as things change, we don’t then find ourselves in the opposite situation next year that we forgot to increase our withholdings. But I mean, back to the kind of the point you made really close to beginning, Ben, this is about having intentional approach to what we’re doing.

Benjamin Brandt: I couldn’t agree more. It’s all about sanding off the rough edges of that biggest bill you’re going to have to pay in retirement, that’s your retirement tax. That’s 30 years of accumulated cash flows and who’s going to pay taxes on that. So it’s very rarely one big thing that that’s going to save us a huge amount of money one year over next year, but it’s going to be sanding off those rough edges. What small decisions can we make over and over again to give us an advantage over the tax man.

Steven Jarvis: Definitely. And I would just really like to encourage everyone listening to just stop for a second and think, okay, how much tax did I pay last year? Not how much of a refund did I get? Not how much of a check did I write at the end of the year, but just think about that for a second. And if you can’t confidently answer that question for yourself, this is something you need to be looking at more often. Go back to last year, make sure you look at it this year. Especially as we get close to retirement and into retirement, taxes is going to be the single largest expense you have. And it’s just… I don’t know if it’s ironic or what the right word for it is, but my experience is that most people, even though that is their largest expense, they can’t tell you how much that expense is.

And if we set aside taxes for just a second and just started asking people what their biggest expense was and how much it was, I mean, you would expect that people could tell you how much their paying for their biggest expense. People can tell you how much they’re paying for their house or for their kids college, health insurance. We all know these numbers, but most of us don’t know how much we’re paying in taxes. And so it’s really hard to be motivated and focused to do something about a number we’re not even really aware of.

Benjamin Brandt: Well, Steven, I sure appreciate your two time today. I know we don’t have an official sign off yet. That’s to be announced at a later date, but I’ll see you in a couple weeks. How’s that sound?

Steven Jarvis: That sounds great Ben. I’m looking forward to doing these episodes together in person. It’ll be a lot of fun.

Benjamin Brandt: We’ll see you on the first and 15th, just like payday.