This post is from new staff writer William Cowie.
How do you approach your income tax withholding? Do you opt for a higher withholding in order to get a refund, like 85 percent of all Americans (according to a recent survey)? Or do you go for the minimum and pay in when you file your taxes? Most articles you read on this topic appear in April, but isn’t that a little late to do something about it?
Instead, let’s look at the issue before tax time is upon us again.
Skip the refund
Several personal finance bloggers, like Luke Landes at Consumerism Commentary and J.D. Roth at Get Rich Slowly, say opting for larger withholding to get a refund is not the smartest choice. Although there are some who say it’s neither good nor bad to over-withhold, a casual survey of the personal finance blogosphere shows most say the refund way is a bad way to go, and here’s why:
You don’t earn any interest on money you give the government before you need to. Why would you let someone else sit on what is really your money when you could be putting that somewhere and earning interest on it?
2. Out of reach
The future hasn’t stopped being uncertain. What would happen if something unforeseen came up and you need the money? Your government is not going to have an sympathetic ear and let you have that money back.
3. You can save properly yourself
In other words, if a savings account is what you want, you have many better options than leaving the money in Uncle Sam’s care.
4. You might just spend the refund windfall
When you drill down into this one, it’s like the opposite of the previous argument, which says you’re smart enough to save wisely. This argument says no, you might not save that expected windfall. You might squander it, you reckless rascal you!
5. You’re missing out on investment opportunities
You could be investing your money and earning big bucks while waiting to file your return, instead of letting it just languish there in some government account earning zip… an expansion of #1 above.
6. What’s the government doing with it?
This line of reasoning goes something like this: government is bad, big government even worse. What are they going to be doing with your money? Like the ingredients of bologna or summer sausage, you really don’t want to know. So don’t give it to them unless they come and pry it out of you with an April 15 deadline.
Go for the refund
For some reason, almost no experts take the view that it’s smart to opt for larger tax withholding in order to get a refund. What this debate amounts to, then, is the experts vs. the masses, because, as noted above, 85 percent of us, the masses, think the refund strategy is the way to go.
Why do we listen to the experts and then have the nerve to do exactly the opposite? Is it because we are just not smart enough, or may there a method to our madness?
I believe there is a method, and it’s not madness at all.
1. Interest foregone is immaterial
Exactly how much interest do you forego by giving the government more money and then getting it back? Let’s say, for the sake of argument, that your refund is $1,200, and you get that because you, inadvertently or on purpose, have $100 a month too much deducted for your income tax. If your savings account pays you 1 percent per year (about average these days) the grand total of interest you are sacrificing for your folly is $6.50 — that’s less than a single Big Mac meal.
2. The penalty
In the opposite corner of the interest you lose is the penalty you run the risk of paying. Most commentators are strangely silent about this issue. I don’t know why, because in my book this is huge. How do I know that? It hit me one year when just a few unusual items, like a prior year state tax refund, pushed my Federal tax liability over the amount that was withheld. Uncle Sam doesn’t like that, so much so that he whacks you with a penalty of 10 penalty.
That’s a whole lot more than you will earn on any savings account!
Here’s the fundamental problem: our taxes are hard to track during a year. The government doesn’t send you a statement, like you get for your 401(k) for example, to tell you where you stand. If you get any income beyond a simple paycheck, you’re in murky water.
It’s just not worth the risk, I decided, so I went from sailing close to the wind to over-withholding.
That’s when I discovered several other benefits not too many people talk about.
3. Incentive to file early
Every year I was among the hordes who scrambled around in early April to get my taxes mailed off before the dreaded 15th deadline.
Now that I know I’m gonna get a refund, I let my imperfection run free. Like a kid, I’m on my taxes early to get my money, and by the time others do the April scramble, I’m counting my refund bucks like Scrooge McDuck. The previous pain and drag became an annual treasure hunt.
Is that so bad?
4. Big budget
If you’re a home owner, you’re well acquainted with the myth that a home is an investment. You know the truth: a home is nothing but an insatiable money pit. Every year there’s something: new roof, new fence, exterior repainting….
I know, the experts say you should be perfect and save for those things properly, with a real savings account. You know, the type that pays a fraction of a percent in interest each year. So, every year, when we get our refund, we see how much it is, and then we see which holes we can plug this year with what has become our “annual budget.”
After we celebrate with a nice dinner, of course.
We still have an emergency account and we still save up for special things, but what’s so terrible about turning the necessity of filing taxes from an unpleasant event to a nice one? While recklessly blowing off all of fifty four cents a month?
Nobody has been able to answer that one yet.
5. It’s right after Christmas
For many people, those big circles of friends, family and extended family mean they buy a lot gifts over Christmas, including some last minute surprises for people who invite them to a Christmas dinner, but for which they didn’t plan by buying gifts on sale after last year’s Christmas.
I don’t know about you, but come the New Year, all our money fountains are cleaned out. Should that happen to perfectly planning people? Probably not. Does it happen? I’ll let you answer that one.
And so, rather than beat myself up trying to be perfect, I follow a system that works very well, one which turns my imperfection into an asset, not a liability.
I like the idea that soon after Christmas, I know that tax money will be coming in, not going out.
With apologies to the well-known MasterCard ad:
- Interest foregone by letting Uncle Sam hold onto my money: $6.50
- Priority Mail postage to get my return in early: $5.95
- Peace of mind, knowing I will get money, not pay it: Priceless
Which strategy do you follow? Why?