Tax witholding

[Lindley]

I was thinking today about tax withholding. Normally, an employer withholds a percentage of your wages for federal and state taxes, so that you aren't hit with a massive amount due at tax time (and may even be owed a refund).

The prevailing wisdom is that your withholding should not be excessive; you should reach tax season as close to break-even as possible, because this puts the money in your pocket to be invested rather than in the government's pocket.

But what I'm wondering is, why stop there? Federal taxes can be a lot of money. If I take that money home and keep it in a high-yield savings account until tax time, I generate more money for myself in the form of interest. (Sure, that's taxable too, but not all of it!)

So is tax withholding even a good idea at all?

 

[Mr. Laser Beam]

The prevailing wisdom is that your withholding should not be excessive; you should reach tax season as close to break-even as possible, because this puts the money in your pocket to be invested rather than in the government's pocket.

My bank account doesn't earn interest, so as long as I get the money back via refund, I'm of the "meh" mind on that. I do not have an excessive amount of withholding; I have one allowance, for myself, and that's it.

And before anybody trots out the overused phrase "giving the government an interest-free loan" for the 1,000,000,000th time: I don't care. I get the money BACK. It all works out in the end.

 

[RoJoHen]

So is tax withholding even a good idea at all?

Yes, because getting your refund is fun!

 

[Holdfast]

But what I'm wondering is, why stop there? Federal taxes can be a lot of money. If I take that money home and keep it in a high-yield savings account until tax time, I generate more money for myself in the form of interest. (Sure, that's taxable too, but not all of it!)

So is tax withholding even a good idea at all?

Depends entirely on how disciplined an individual you are with the money. The only real benefit of withholding to individuals rather than the government is accounting predictability. If you are disciplined enough with your finances and knowledgeable enough about your financial position to leverage the money in the meantime and can always guarantee sufficient liquidity to pay your taxes at the time they're due, withholding does you no favours.

In the UK, the government uses effectively mandatory payroll deductions through the pay-as-you-earn system (withholding) to ensure employees pay their taxes. However self-employed people like myself do not use PAYE, which means nothing is withheld. I pay my taxes at the end of the year (though I also have to pay something on account for the following year too - a function of what I paid the preceding year - so there is some mandatory withholding enforced on me too). In the meantime, I get to enjoy the benefit of all the extra money in my account, and can invest it where I like. It's a significant extra bonus.

But you NEED to be disciplined if you play this game.

And before anybody trots out the overused phrase "giving the government an interest-free loan" for the 1,000,000,000th time: I don't care. I get the money BACK. It all works out in the end.

And as been pointed out ad nauseam by others to you, it doesn't work out balanced in the end because you deliberately choose not to understand the concept of leverage. But wallow in your wilful ignorance all you like; it's no skin off anyone else's nose.

 

[PKTrekGirl]

So is tax withholding even a good idea at all?

YES.

And keep in mind here that this advice is coming from a CPA who did taxes for MANY years. Please do not listen to advice from people who do not know (and I mean KNOW, not 'think they know') American tax law, or you will be in deep shit before you know it.


As you may or many not be aware, there are basically two ways to pay your taxes during the year. The first is withholding, with which you are already familiar, and which is the easiest and least risky method. However, many people in the US pay what are called quarterly estimated tax payments. Mostly, these estimated tax payments are paid by self-employed individuals who do not have access to withholding. So they pay in to the IRS and state on a quarterly basis using coupons that get generated with their previous year's tax return by their tax accountant.

Here is the important part:
What we have in the US are called safe-harbor rules. Under the safe harbor rules, if you pay in during the year (via withholding or estimated tax payments) the equivalent of your PRIOR year's tax liability, you will not be charged interest and penalties if you end up owing at the end of the year. But you HAVE to pay 1/4 of your prior year's tax liability to the IRS quarterly - either via withholding or estimated tax payments, to qualify for the safe harbor.

Waiting until the end of the year to pay the whole amount you owe with your return will exclude you from the safe harbor and put you in an interest/penalty generating situation. And might also get you into protracted correspondence with the IRS (and your state as well, if you decide to follow this same hair-brained scheme with them). Something you do NOT want. You will be charged a stiff penalty for being late on each of your quarterly estimated tax payments, and you will be charged interest on the outstanding unpaid balance for each quarter. AND, for claiming 'exempt' on your W-4 (which is what you will have to do in order to get zero withholding taken out of your checks), you might very well end up on the IRS's 'flagged' list of people they are watching as potential tax protesters, etc.

Long story short - stopping your withholding is a REALLY, REALLY bad idea.

If you do not believe me...or someone in this thread tries to tell you differently, please call a local area CPA. He/she will confirm my story, and will save you from yourself.

 

[PKTrekGirl]

And before anybody trots out the overused phrase "giving the government an interest-free loan" for the 1,000,000,000th time: I don't care. I get the money BACK. It all works out in the end.

And as been pointed out ad nauseam by others to you, it doesn't work out balanced in the end because you deliberately choose not to understand the concept of leverage. But wallow in your wilful ignorance all you like; it's no skin off anyone else's nose.

Holdfast, don't be too quick to come down on him in this instance. If he is claiming 1 exemption during the year, and cannot itemize his deductions (which I doubt he can, since I doubt he owns a house or gives bucketfuls of money to charity) I would guess his tax refund at the end of the year is not that large. If it was more than about $1,000, I'd be REALLY surprised, and I'm guessing a fair amount lower (unless he has recently come into a new, highly-paid career...which last I checked was not on the horizon). We are not talking here about giving the government an interest free loan of $30,000 or anything. We are talking about a few hundred bucks...and the peace of mind of knowing that you won't owe interest and penalties at the end of the year, in addition to your unpaid tax liability.

Additionally, I read your post to Lindley, and I assure you that your description of how it works in the UK is NOT the way it works here. And paying everything in at the end of the year, in the US, will get you into a shitload of trouble faster than you can say "Go directly to jail - do not pass GO, do not collect $200".

Anyway...you guys can believe me or not. It's completely up to you. But I assure you that any US CPA who has done any amount of tax work will tell Lindley exactly what I did - under no circumstances should he stop his withholding.

He might could tweak it to get it closer to the break-even. But even then, under NO circumstances should he pay in during the year less than his prior year's tax liability.

To do that is just all kinds of stupid, and only asking for boatloads of grief.

 

[Mr. Laser Beam]

^ Actually I do own a house and itemize deductions. But thanks for the kind words anyway.

My refunds are not that large, though. So the gov't doesn't get THAT much of my money.

 

[PKTrekGirl]

^ Actually I do own a house and itemize deductions. But thanks for the kind words anyway.

My refunds are not that large, though. So the gov't doesn't get THAT much of my money.

Well, I don't know what 'not that large' means. Are we talking in the 'less than $1,000 range'? I don't know what your itemized deductions look like (nor what your AGI is) so now we are ballparking it a lot more than if you were using the (known) standard deduction.

If your refund is less than, say, about $1,000, depending upon your income, I'd maybe hold steady at 1 exemption and tell everyone to go jump in the lake. Because writing a check in April is a drag...and the interest you are not getting on an interest-free loan to the government of less than $1,000 +/- is just not worth the worry and stress of wondering how much you are gonna owe, blah, blah, blah. I mean, what would you get on that amount in a money market account? Diddly-squat, last I checked.

If it's more than $1,000 or so, depending upon your income you might could tweak it a bit to get closer to break-even.

But seriously...just do the math. If your refund is low enough to where you are okay with NOT earning interest on that money during the year because the potential earnings are so small as to not be worth it...then keep doing what you are doing. But if you think you can add an exemption and get closer to break-even without cutting it too close (look in your last year's tax booklet to see the difference between 1 exemption and 2 exemptions on your AGI), do it.

 

[Mr. Laser Beam]

^ Actually I do own a house and itemize deductions. But thanks for the kind words anyway.

My refunds are not that large, though. So the gov't doesn't get THAT much of my money.

Well, I don't know what 'not that large' means. Are we talking in the 'less than $1,000 range'?

Yep.

 

[RoJoHen]

I always claim 0, and I have been getting roughly $600-800 back ever since I was 16...except this year, where I got $1500 for some reason that I can't quite yet figure out (but I ain't complainin'!).

I would be sad if I didn't get that little bonus every year. I know it was my money all along, but I never missed it, so I treat it like a gift.

 

[PKTrekGirl]

I always claim 0, and I have been getting roughly $600-800 back ever since I was 16...except this year, where I got $1500 for some reason that I can't quite yet figure out (but I ain't complainin'!).

I would be sad if I didn't get that little bonus every year. I know it was my money all along, but I never missed it, so I treat it like a gift.

Yep. I can appreciate that. I'd much rather be looking forward to a refund in April than stressing about whether or not the car is going to break down on the exact day I have to write a big whopping CHECK to the IRS.

The bottom line is your own comfort level with your missed opportunity for earnings on your money. That $1,500 at 3% interest would have netted you what? $45? And actually not even that much since you would have received the $1,500 in increments throughout the year and not all at the beginning of the year. Is that missed income opportunity worth it to you? Only you can answer that.

All I know is that, knowing what I know as a CPA, I'd rather be worrying about just about ANYTHING other than potential IRS troubles.

 

[Gaseous Anomaly]

I claim single 0 for my with-holding. I find it better to get a refund from the government than trying to come up with an extra thousand or two pay the IRS every year. The trick is to get back as little refund as possible but the variables very so much it really is difficult to calculate properly.

Listen to PK Trek Girl, she is wise. It only takes one bad year to screw you.

 

[RoJoHen]

I always claim 0, and I have been getting roughly $600-800 back ever since I was 16...except this year, where I got $1500 for some reason that I can't quite yet figure out (but I ain't complainin'!).

I would be sad if I didn't get that little bonus every year. I know it was my money all along, but I never missed it, so I treat it like a gift.

Yep. I can appreciate that. I'd much rather be looking forward to a refund in April than stressing about whether or not the car is going to break down on the exact day I have to write a big whopping CHECK to the IRS.

The bottom line is your own comfort level with your missed opportunity for earnings on your money. That $1,500 at 3% interest would have netted you what? $45? And actually not even that much since you would have received the $1,500 in increments throughout the year and not all at the beginning of the year. Is that missed income opportunity worth it to you? Only you can answer that.

I know that if I got that money incrementally throughout the year, I would just waste it on fast food or booze or something. When I get it all as one big chunk, I can use it to invest on something way more awesome.

 

[Gaseous Anomaly]

I always claim 0, and I have been getting roughly $600-800 back ever since I was 16...except this year, where I got $1500 for some reason that I can't quite yet figure out (but I ain't complainin'!).

I would be sad if I didn't get that little bonus every year. I know it was my money all along, but I never missed it, so I treat it like a gift.

Yep. I can appreciate that. I'd much rather be looking forward to a refund in April than stressing about whether or not the car is going to break down on the exact day I have to write a big whopping CHECK to the IRS.

The bottom line is your own comfort level with your missed opportunity for earnings on your money. That $1,500 at 3% interest would have netted you what? $45? And actually not even that much since you would have received the $1,500 in increments throughout the year and not all at the beginning of the year. Is that missed income opportunity worth it to you? Only you can answer that.

I know that if I got that money incrementally throughout the year, I would just waste it on fast food or booze or something. When I get it all as one big chunk, I can use it to invest on something way more awesome.

My thoughts exactly!

 

[DonIago]

Apparently I did something right in 2010...I ended up owning Uncle Sam $1. I was rather dubious of this since I do my taxes online, but ran the number at a separate tax site (SOP for me really...I like the confirmation and all I tend to have is a single W-2) and got the same result.

It'll likely cost him more to process the payment than it's worth.

 

[PKTrekGirl]

I know that if I got that money incrementally throughout the year, I would just waste it on fast food or booze or something. When I get it all as one big chunk, I can use it to invest on something way more awesome.

Yep. Another valid point. Part of this whole equation has nothing to do with interest rates and money market accounts. It has to do with knowing yourself.

To some people, an extra $125 per month in their pocket (as it would have been for your $1,500) means more money in savings. To others, it means crappin' it away on impulse purchases and a billion different things you'll have no recollection of later.

While to just about everyone, getting a check from the IRS for $1,500 means something like "New TV" or "New computer" or "Home improvement" or "Car downpayment' or some other thing where they will have something worthwhile or useful to show. Or it could just as easily go into savings. The only difference being your <$45 in opportunity cost.

Don't get me wrong - I'm a big fan of saving. Everyone who can be doing a 401(k), for example, should be doing a 401(k). No excuses. Things like that, I'm completely on-board with. I'm also on-board with tweaking your withholding closer to break-even if you are WAY overpaid (as in, several thousands overpaid). And saving up a stash of cash for if you lose your job or whatever (outside your 401(k) ). And I used to be a big fan of home ownership...until this current real estate market...where I myself have lost over $50,000 in equity in my house in only 3 years (don't get me started).

It is one thing to be responsible about money and plan to take care of yourself. It is quite another to make yourself crazy, beating yourself up over nickels and dimes when at a certain level, knowing yourself is more important.

 

[Holdfast]

Additionally, I read your post to Lindley, and I assure you that your description of how it works in the UK is NOT the way it works here.

Fair enough; obviously I'm more familiar with the UK tax environment since that's where I primarily operate in. And I would strongly echo your comment in a later post somewhere where you said it's vitally important to know your own habits when it comes to managing money. If someone is just going to fritter away extra money, and not have any left at the end of the year, then obviously they shouldn't stop witholding. I would hope that in an ideal world most wouldn't use money that way, but I absolutely take your point. And yeah, the sums involved need to be significant enough to be worthwhile. Fundamentally though, it's just a question of having sufficient overall reserves in relatively fungible accounts to meet potential tax bills.

 

[RoJoHen]

If someone is just going to fritter away extra money, and not have any left at the end of the year, then obviously they shouldn't stop witholding. I would hope that in an ideal world most wouldn't use money that way, but I absolutely take your point.

It really depends on how much money we're talking here. I mean, for me, it would be about $4 a day, which I personally don't consider a whole lot of money. I might not squander it all away, but it's not a significant enough amount that I would track and worry about saving. It would likely end up getting spent on food, or one more beer at the bar, or filling up my gas tank, or a trip to Starbucks...things that I might do anyway, so it really doesn't matter to me.

The large lump sum that I get with my refund simply feels like more money. It's like the government has saved it for me while I wasn't looking and gave it back to me as a gift. This year it came in particularly handy because I moved into a new house and got stuck paying 1) rent for my old house, 2) rent for my new house, and 3) and security deposit for my new house. So I basically had 3X the expenses in February than I normally would. My tax refund helped offset that extra expense.

Last year I used it help pay off a credit card. The year before that I used it towards a new MacBook. It helps that tax season ends right around my birthday.

I guess I'm just used to living with a certain level of income, so the tax withholding doesn't matter to me. I don't need that extra $100 a month for anything, so if the government wants to stash it away until tax season, I say let them! It probably doesn't help that I've been a bartender this whole time, so most of my income is in petty cash anyway. My paychecks are meaningless to me.

 

[Holdfast]

It probably doesn't help that I've been a bartender this whole time, so most of my income is in petty cash anyway. My paychecks are meaningless to me.

Out of curiosity, how do tips interact with taxes in the US?

 

[RoJoHen]

That depends entirely on how honest you want to be with the government.

It's basically up to you to track and claim your income. Different places do different things. For example, with the computers we have at work, I can claim absolutely nothing if I choose to. Other places will at least make you claim your credit card tips, as they can be tracked. It's really all up to the individual. That said, the less I claim, the bigger my paychecks are. If I claim too much, I sometimes don't get a paycheck at all.

I am actually going to be starting a new, "real" just next week, and it will be interesting (and scary!) to see how much money I will actually be making now that taxes will be taken out of everything.