You know that great feeling you get in the new year when you find out you’re going to get back a huge tax refund? My goal of this post is to make sure you never have that experience again. I want to empower you to live your financial life so responsibly that you are eager to set your sights on getting back a big fat goose egg from uncle sam…that means zero.
I work in a large finance department with some very intelligent people. I’ve been surprised to find that even among my finance peers, many of them are somewhat unaware of their general tax situations. When I tell them I’ve been withholding no federal income tax for the last 8 months, they usually think I’ve cooked up some complex tax strategy and ask me to explain.
Why I haven’t been paying taxes
My company did well the year before last, and this past year I earned a $20K bonus (my biggest paycheck ever), $5K of which the IRS snatched before I even got it. In general, the IRS immediately seizes 25% of all supplemental income (like bonuses). I knew I was only going to owe about $6K in federal income taxes for the entire year, so between the $1K which had already been withheld from my paychecks and the $5K withheld from my bonus, I had already paid this year’s taxes.
Adjust your allowances: Our friend the W-4
So did I sit back and watch as $400 continued to be withheld from of my paycheck? Heck no I didn’t! I jacked my allowances up so high that there would be no chance of any future withholdings.
You know that form HR makes you fill out when you start a new job? It’s called a W-4, and it is designed both to confuse you and to indicate how much you want withheld from your paycheck for income taxes.
If you have a history of refunds, you should consider increasing your allowances. If you’re dying to know what an allowance actually is, it’s a dollar amount by which your taxable income is reduced ($3,950 in 2014). If you indicate less taxable income (by increasing your allowances), you will have fewer dollars withheld from your paycheck. If you are still confused, you can use this w4 estimator to help you see what you should be withholding.
If I had continued to have taxes withheld beyond April when I got my bonus, I’d be getting back over $4K this year. But I’ve already pocketed that money and instead will be getting back around $700 (I was aiming for 0, maybe next year).
Why do we get tax refunds?
If you make over a certain dollar amount, you will owe income taxes to the federal government. Instead of having you pay your taxes when you file them after the end of the year, your employer usually withholds a portion of each paycheck and remits it to the government. At the end of the year when you file your taxes, you are just paying (or receiving) the difference between what you already paid through withholdings and what you actually owe.
Getting a refund is like doing drugs
When you receive a refund from the federal government, you will have a surge of dopamine through your brain making you feel really excited, but don’t let that convince you that a refund is a good thing. They’re borrowing your money without even paying you interest (which they will charge you if you hold on to their money for too long).
Investing is better than nothing
One argument against refunds is the fact that the government is holding our money that we could otherwise be investing. For most of us, though, the reality is that the difference would be insignificant.
For example, Fred got a refund of $500 and was ecstatic. Susie made fun of Fred and told him that had he managed his money better, he could have invested that $500 rather than giving an interest-free loan to the government.
While Susie has a point, Fred really wouldn’t be much better off. Even if he had the $500 dollars for the whole year and stuck it in his 1% savings account, he’d only be $5 richer at the end of the year.
But $5 is better than nothing! You could also use it to build up an emergency fund sooner or to pay off debt.
Why refunds are nothing to brag about
It’s more the principle that bothers me. I want that $4K when I earn it rather than letting the government manage it all year until I file for my refund. Why overpay if you don’t have to? Minimizing your refund signifies that you’re being intentional with your money. It reflects a proactive financial mindset.
If you really like the “forced savings” aspect of overpaying the government, consider doing the forcing yourself through automation! Instead of having your employer send your extra money to the government, why not have it automatically withdrawn from your paycheck to a separate savings account? Let the government focus on what they specialize in (this does not include money management).
Brag all you want about your refund, but don’t also claim to be financially responsible.
Basic tax planning is not difficult. When you adjust your allowances on your W-4 in order to avoid overpaying your taxes, you are doing tax planning!
Be careful not to withhold too little
The government couldn’t care less if you withhold way too much. In fact, they count on it. But if you withhold too little, you can bet they’ll penalize you for it. Too avoid the penalty for underpayment, you need to either:
1: Owe less than $1,000 in tax after subtracting your withholding and estimated tax payments, or
2: Pay at least 90% of the tax for the current year or 100% of the tax shown on the return for the prior year, whichever is smaller.
Don’t listen to HR – A real life example
Whatever you do, don’t put all of your trust in HR to do the right thing. I had a friend email me with a question about his allowances. He makes $45K and has 2 kids. Since I knew he wouldn’t owe any taxes, I told him to claim the maximum amount on his W-4. This was his response:
So I went to HR again today and they were really concerned that I wanted to put the max on my allowances. I would have a total of 9. They claim I will owe taxes if I put that many on my w4. I just gave up on the argument and left it at 5. I didn’t know what else to say to them.
The resident ahead of me is married & has 2 kids, same salary as myself, and he got $10k back on his return last year. So the whole thing is weird to me. I’m not sure why HR is so concerned. Anyways, maybe I can pay you to do my taxes for 2014 and when I get my fat return check I can take that to HR and have them change the allowances for me.
That got me all fired up, so I sent him back this quick tax analysis from a simple online calculator and told him to show it to his HR tax experts.
He responded with this:
Good news, I convinced them to allow me to increase my allowances. I showed them your graph. So I shouldn’t have much taken out of my paycheck for taxes. Thanks for the advice.
Now instead of pointlessly sending the government money only to have them return all of it, he’ll just keep it all. I think that’s how it should be.
It may not be a big deal in the grand scheme of things, but it is one of the few things I feel strongly about. How do you feel about it?