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Do you let — or request that — your employer withhold more money than necessary from each paycheck for income taxes, and then receive a lump sum refund each spring? If so, you are not alone. The majority of U.S. taxpayers over–withhold. However, you may want to reconsider this unique practice of letting Uncle Sam have an interest–free loan of your money every year. There are a number of better ways you can use your hard–earned money.
It is an odd American tradition. On one hand, many of us complain about high taxes and how much money gets taken from our paychecks each week. On the other hand, of the more than 131.3 million individual federal income tax filings in 2003 (the latest figures available), 102 million had more money taken out than they owed, only to receive refunds. The average size of the refund was $2,154.1 That means, on average, each person or household had nearly $180 over–withheld each month, either by accident or design.
"In effect, what they are doing is lending the government their money at zero percent interest," explains Leo C. Hodges, a tax analysis writer, as well as Executive Vice President and Legal Counsel for Pentera Group, Inc., an information resources company.
Most of us deliberately over–withhold, Hodges told New York Life. Some people fear a large tax bill on April 15, so they "do it deliberately to insure against an unpleasant surprise. Plus, there are many people who use over–withholding as a form of forced savings. Even though they do not receive any interest on their money, they look forward to getting that large chunk of cash back each year in the form of a refund."
Some people view their refunds as fun money. They use the money to pay for that new flat–screen HDTV or take a trip to Disney World. They look forward to their refund each year as if it were a pay bonus rather than a refund of their own money.
The biggest drawbacks to this practice, says Hodges, are the loss of use of the cash during the year, as well as loss of interest that this money could be earning. "Even though taxpayers must pay interest on underpayments, the government does not pay interest on over–withheld amounts," he explains. "It's a great deal for the government."
The actual amount of lost interest may seem small — perhaps under $100 total on an average $2,000 overpayment — but it does add up to nearly $220 billion in refunds to taxpayers each year. 2
Is there a better way? Here are some recommendations from tax specialists:
- File a new W–4 with your employer. Get your withholding deductions in line with your actual tax liability. Make your goal to break even or receive only a small refund each spring.
- Find a better way to save money. If you like the idea of using tax over–withholding as a forced savings program, there are several more profitable ways to save money. For example, if your employer offers a 401(k) qualified plan, have the money allocated into that. The amount you contribute is deducted from your income before taxes (which may save you as much as $500 on your income taxes on $2,000, if you are in the 25% tax bracket). Plus, some employers match up to a certain percentage of contributions. (So, between tax savings and employer contributions, you could be looking at leveraging that $2,000 into more than $4,500 each year, plus interest.4 )
Another option might be an automatic deduction from your checking or savings account into an IRA. Contribute the maximum amount each year to an IRA, and you are making big strides toward accumulating money for your retirement. For example, if you saved $2,000 a year, and the money earned just 5%, compounded monthly, that money would total $25,988 in ten years. Keep it up for 20 years, and you will have nearly $68,800. 5
Or, if you do want to use this money for immediate fun — like that spring cruise to the Caribbean — consider setting up a "vacation fund" savings account. Making regular deposits each month not only build discipline, but it also creates a way to earn interest for big–ticket expenses.
- Pay down debts. Imagine that you are a taxpayer who lends the federal government $180 a month, interest free. You also probably have credit cards. If you allocated that money to debt reduction, you could be reducing your debt load and saving as much as $300 annually in credit card interest payments. 6
The bottom line: It is understandable that many people accept or even plan for over–withholding. However, there are a number of other — and better — options that can give you enhanced value for your money.
Talk to your benefit manager at work today. Also, visit with your New York Life Insurance Company agent to discuss the many money management options available to help you arrange your assets and develop a financial strategy.
This article is for informational purposes only. Neither New York Life nor its agents are in the business of offering tax, legal or accounting advice. Please consult your own professional advisors for tax, legal, and accounting advice.
1 "Tax Stats at a Glance," Internal Revenue Service, October 6, 2005 (www.irs.gov)
3 "Seven Things To Do With Your Tax Refund," by Scott Reeves, Forbes.com, 3/18/05 (www.forbes.com)
4 These numbers are theoretical and provided solely for illustration purposes. They do not represent any specific returns, taxes or products.
5 Calculations provided by www.moneychimp.com.
6 Assumed interest rate of 16%. Credit card interest rates vary. This rate is for illustration purposes only.
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