Manage Your Personal Finances, Master Your Life: Will Lowering Tax Withholdings Increase Savings?


Manage Your Personal Finances, Master Your Life: Will Lowering Tax Withholdings Increase Savings?

lowering tax withholdings

Federal income tax returns are typically due on April 15 each year.

Getting a big, fat income tax refund can be a satisfying, even exhilarating experience, but the only reason you'll get a refund is if you overpaid your taxes in the first place. You can look at it as a form of forced savings, but for Certified Public Accountant Mark Noel, an oversized federal tax refund amounts to nothing more than giving the government an interest-free loan.

Pay as You Go

The bulk of the money needed to operate the federal government comes from personal income taxes. The Internal Revenue Service, the agency charged with collecting federal income taxes, has a simple rule for determining whether or not your income is taxable: if it's not exempted from taxes by law, it's taxable. While you only have to file your tax return once per year, the federal income tax system is a pay-as-you-go system, which means you have to pay taxes on your income as you earn it. "If you work as a employee, your boss will typically handle that for you by withholding tax money from your paycheck and sending it to the government," Noel explains. "If you are self-employed, the responsibility falls on your shoulders. In most cases you'll pay your taxes on a quarterly basis."

Withholding

Your employer's payroll department or bookkeeper will use the information you provide on Form W-4 to determine how much money to withhold from your paycheck. You have a significant amount of control over that amount, at least as far as the federal income tax portion is concerned. Your withholding is affected by such factors as your marital status, the number of dependents you can claim, whether you have more than one job and the amount of your itemized deductions. You can adjust the amount you have withheld by adjusting your W-4, and if you find the adjustment didn't have the desired effect, you can always submit another W-4. There's no limit to how frequently you can make changes to the form.

Tax Neutral

The higher the number of allowances you claim on Form W-4, the less money your employer will withhold from your paycheck. The challenge is getting your withholdings to result in a tax-neutral outcome. If your employer withholds too little, you'll end up having to pay when you file your federal income tax return, and that's never fun. If too much is withheld, you give up access to money that you could have otherwise used for your own benefit. "The ideal is to shoot for a tax-neutral result," Noel advises. "That way you don't owe any additional taxes, and you get a bigger paycheck all year long."

Saving the Difference

Some people look at their tax refund as free money. It's a windfall: they can go on vacation, buy a new refrigerator -- or save it. "It's an 'out of sight, out of mind' mentality," Noel says. But, he adds, there is a better way to build your nest egg without giving Uncle Sam an interest-free loan. "If you set up an automatic draft from your paycheck into your savings account, you never see the money so you are less likely to spend it. At the end of the year, you not only have the same amount you would have received as a tax refund, but you also have the interest that money earned for you."

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