Are You Overwithholding on Your Taxes?

Hello Savvy Saver!

I’m actually not specifically talking about overpaying your taxes here.

I want to focus this short savings tip on the Overwithholding that people are prone to do.

There are two reasons people overwithhold on their taxes:

  1. They misunderstand what the withholding is, and how it plays into their actual income tax due (or not) when filing or
  2. They understand how everything works, but they’re afraid to owe taxes to the IRS come tax time.

We’ll address both of these issues here.

The government has been withholding taxes since World War II. Before that, every April 15th, everyone was paying all of their taxes. It created quite a cash flow situation for the government, especially during times of war. To improve the cash flow situation (and, in my conspiracy-oriented mind, to also make us a bit more unaware of how much we are truly paying in taxes) the government passed a law that required withholdings.

Your HR department will give you a W4 and you’ll usually mark the number of dependents, any additional withholdings required, etc. The number of dependents determines what your withholdings will be. A hypothetical: Your salary is $50,000 per year, and you have three dependents. You may see withholdings of $150 per month. If you increase the number of dependents, the amount withheld will decrease. This is how you’ll manipulate the withholdings to be either just right, or a bit short.

Basically the government is saying that because you’re working, they’re confident you’re going to owe them some money. It’s in the government’s best interest to overestimate what you’ll owe, because then they receive an interest-free loan. As a result of that, the tables that are used to calculate what should be withheld are going to be more aggressive in terms of what you should withhold.

In our example, by the end of 12 months, you would have withheld $1,800. If your actual tax liability is only $1,200 then you would receive a refund of $600. (Please take note, you did pay taxes. You paid $1,200. Please don’t tell me that in this situation you did not pay taxes, but received a refund!) Your interest-free loan to the government was $600. They were able to use that money until you called for it back by filing a return that showed you had overpaid.

So, for those of you that didn’t really understand the why behind this, there you have it.

For Those that Have a Tough Time Saving

Listen, if you can “save” your money by automatically deducting it and handing it off to the government, then you can certainly save it by auto-deducting it from your paycheck and deferring it to a savings account. Most employers will allow you to direct deposit to multiple institutions. Take the refund you received this year, divide it by twelve, and set up that amount as a direct deposit into a high-yield savings account. The psychological effect will be just about the same — you’ll never “see” that money and be tempted to spend it.

With only a $600 example, the difference isn’t too dramatic. Saving that money would provide very little in terms of interest (less than $10 annually). It’s the principle that counts (no pun intended)! The average refund size in the US is actually much higher than that. You’re basically leaving money on the table!

We’ll save overpaying and all of the strategies involved there for another day…