Tax Withholding as Forced Savings
What is it?
You work, you receive a regular paycheck, and your employer withholds a portion of your earnings to pay federal income taxes. The amount your employer withholds is based on your filing status and number of exemptions you claimed on your W-4 form. You hate to pay taxes at the end of the year, so last year you claimed fewer exemptions than those to which you were entitled. Or perhaps you elected to have taxes withheld at a single rate even though you’re married. In either case, your employer processed your W-4 form and withheld more than would have been necessary.
Now it is April of the following year and you are just completing your income tax return. With great anticipation, you punch the last few numbers into your calculator to find out the amount of your tax refund for this year. You will get back $3,000. What can you do with that money? Scuba in Aruba? Shop till you drop? Remodel the kitchen, pay off the car loan, or pay that big annual insurance premium? It is great to get a large tax refund. It is like a Christmas Club in June.
What you have done is what many taxpayers do: use federal income tax withholding as a forced savings plan. The money taken out of your check every week is hardly missed. It’s gone before you ever see it. You plan your weekly budget around what is left, and you have a sum of money to show for it at the end of the year. It works, but it is probably not the best way to save money.
What is wrong with using federal income tax withholdings as a forced savings plan?
The IRS doesn’t pay interest on excess withholdings
The IRS is not a bank. In other words, you can’t make early withdrawals, you don’t have check writing privileges, you don’t have ATM access, and most importantly, YOU DON’T RECEIVE INTEREST. Money withheld between January and December of one year can remain at the IRS until June of the following year. The IRS holds your cash for 6 to 18 months and never pays you a dime of interest.
Lost opportunity costs
Even a basic savings account will pay you a little interest on your deposits. Money deposited into a money market mutual fund or six-month certificate of deposit could yield even more. Rather than withhold an additional $250 of earnings per month to get that $3,000 refund from the IRS, you could have put that money to work.
Better to borrow from the IRS
If the IRS owes you money at the end of the year, then it has been using your money interest-free since it was withheld. If you owe the IRS at the end of the year, then you are using the IRS’s money interest-free. By claiming the maximum number of exemptions to which you are entitled and by claiming the most favorable filing status that applies, you will have the least amount withheld from your earnings. You will probably owe the IRS in April of the following year, but you will pay no interest on the balance you owe, provided you file your returns and make your payment in a timely fashion. You are, in effect, borrowing money from the IRS, interest free. Until April arrives, you can put that money to work earning interest for you.
If you claim more than the maximum number of exemptions to which you are entitled, then you run the risk of underpayment. You could incur penalties. In addition, if you owe more than $1,000, you could be subject to an estimated tax penalty.
When is using withholdings as forced savings a good idea?
If you completely lack discipline with regard to savings, then you might consider federal income tax withholdings as a forced savings plan. The unfortunate alternative might be to minimize your withholdings with good intentions, only to spend the difference on luxury items. This could leave you borrowing from your credit cards to pay the IRS at tax time. Using withholdings as forced savings will prevent that result, but there might be a better way to implement a forced savings plan. Perhaps the simplest is to have your employer automatically deposit a portion of your earnings into a separate account at your savings bank or credit union. If you don’t trust yourself to leave the balance alone, then you might ask a trusted relative to hold the passbook for you. At least you will be earning interest on your dollars.