I have a good friend who frequently comes over to my house late in the evening to walk the dog with me. It’s a habit he and I developed a few years ago and one which I still cherish to this day. It’s a great way for both of us to chat and discuss topics ranging from relationships and work to travel and video games. One of the topics which comes up relatively often is money. We both enjoy managing and we both marvel at the mistakes some people make. A recurring topic is one of tax returns. My friend is a tax accountant and he’s always amazed at the amount of people who are happy at the end of the year to find out they have a tax return coming. To him this signifies someone who doesn’t understand some basic ideas behind money management and / or can’t be bothered to put in a little effort that could save them a lot of money.
The basic thing you need to understand if you want to know why a tax return is a bad thing is something called “The Time Value of Money”. From the Wikipedia entry:
The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time.
For example, 100 dollars of today’s money invested for one year and earning 5 percent interest will be worth 105 dollars after one year. Therefore, 100 dollars paid now or 105 dollars paid exactly one year from now both have the same value to the recipient who assumes 5 percent interest; using time value of money terminology, 100 dollars invested for one year at 5 percent interest has a future value of 105 dollars.
What the heck does this mean? It means that money today is better than money tomorrow.
Money Now!
Why does money today mean more than money tomorrow? Because of this lovely thing called interest rate. Even today, with interest rates at record lows, you can still find perfectly safe investments like a savings account that will pay you around 3%. That means every dollar you put in at the beginning of the year is worth 1.03 at the end. How does this translate into “Tax returns are bad”? Let me show you.
Let’s say you pay $100 out of your paycheck every month in taxes. Total taxes paid for the year is $1,200. At the end of the year you do your taxes and figure out that you really should have only paid $600 in taxes. Therefore, you are owed a $600 tax return. Sounds good, right? You got $600 back! Except this is actually pretty bad because you gave the government an interest free loan for a year.
Let’s play with this a bit. What if you took the $100 you paid in the first month and only paid $50 of it. All the rest of the months you kept things the same and paid $100. Total taxes paid would be $1150 (1 month at $50 and 11 months at $100). Your actual tax liability would still be $600 so your tax return would be $550 ($1,150 minus $600). Boy, that sounds bad, you got $550 back instead of $600, but hold on! You got an extra $50 in month 1, right? So the total extra money you got this year was actually $600. Except this still doesn’t seem right. Seems like you got the same amount ($600) either way. So what’s the point? Well, the point is the time value of money.
If you had taken that $50 at the beginning of the year and put it in a savings account paying a modest 3% you would have $51.5. That’s an extra $1.50 for absolutely no work. Doesn’t sound like much but it does add up. If you did that every month, you would have a nice amount of cash at the end of the year. Even better, what if you adjusted your income taxes so that you actually owed money at the end of the year? Now it’s the government giving you an interest free loan instead of the other way around. NOTE – Do be careful here. The government frowns on people who do this too much and they do charge interest at some point. So please consult with a professional before you do anything rash. However, my point is that money now is better than money later so extra money in your paycheck now is better than extra money in your tax refund later, and this is the time value of money.
The Math!
If you want to calculate the present value of future money by the way, here’s the formula:
- PV is the value at time=0
- FV is the value at time=n
- i is the rate at which the amount will be compounded each period
- n is the number of periods (not necessarily an integer)
So $1000 a year from now is actually worth:
1000/(1+.03)1 or 1000/1.03 or $970.87.
That’s right, even assuming a very modest interest rate of 3%, $1000 a the end of the year is only worth $970 right now. By the way, this is why you should be careful when someone promises you money some time from now, because it’s not really worth as much as you think. Let’s say someone offered you an investment where you paid in $4,000 now and got $5,000 five years from now. That doesn’t sound too bad, does it? You make $1000 in 5 years! Except that $5,000 in five years is only worth $4310.15 right now. In other words, you’re accepting the risk of whatever investment you’re looking at in order to increase your money’s value by $310 right now. Is that worth it to you? No clue, that’s up to you, but at least now you know the true value of that investment.
If you look at the calculation of future value:
Future value of a present sum
The future value (FV) formula is similar and uses the same variables.
You can see that the $4,000 today would be worth about $4,600 if invested in a 3% savings account. So that investment above is actually better than a simple savings account. However, it could also be riskier. Either way, it’s important to know the true value before you make any kind of decision and for that, you always need to know the value of money today versus the value of money at some other point. That’s why you need to understand the time value of money and how to calculate it.
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Thank you to Your Financial Independence for including one of my articles in their financial independence compilation. Thank you also to Health Fitness Support blog for doing the same in their Total Mind and Body Fitness carnival. Finally, thank you to my old friends at Fitbuff for including my recent article on frugality and dieting in their recent link roundup.
