Until today, I would have strongly recommended the latter, afterall why give the government a tax free loan? However, a few days ago I was filing my fiances taxes and found that her refund was relatively small. She didn’t owe anything, but wasn’t getting a chunk of cash back that she was accustomed to receiving. From an accounting perspective, I tried to explain why this was but she truthfully hates numbers and didn’t want to hear it so I let it go. It struck me as interesting however because I couldn’t think of anything more useless than paying excess income taxes throughout the year in order to get a refund that doesn’t pay interest. However, it all depends on how the money would be used during the year and what it is used for when the lump sum refund comes.
Sad as it may be, when the average person gets an increase in income, their spending increases to use the additional income. Let’s say you normally get a refund of $5,200 each year; were you to receive that on bi-weekly paychecks instead, you would take home an additional $200 per paycheck. Wouldn’t that be wonderful? But what would you do with it? Statistics say that most of us would spend more money in our day-to-day lives and have nothing to show for the additional income. Does that really benefit your financial well-being? Probably not…
What if you got the $5,200 refund in February or March? Perhaps it allows you to take a vacation during the summer without using credit cards, take care of costly home or automotive repairs you couldn’t afford otherwise, or payoff credit card debt lingering from Christmas. So for most of us, it seems much more advantageous to allow the government an interest-free loan by taking higher tax withholding than by receiving a smaller increase on each check.
I can think of two exceptions to this conclusion:
- If you’re underwater already, meaning you’re going into debt each month because the ends do not meet, the additional income on the paycheck-to-paycheck basis would be more useful because it would mitigate the accumulation of debt.
- If you are disciplined enough to use the additional income to save on your own throughout the year, you would not only accumulate the lump sum but would also be paid interest on your savings providing even more income.
The problem is most of us are not disciplined and would allow the additional money to get wrapped up in our day-to-day spending eliminating any substantial financial benefit from your income. I have heard that some individuals will ramp up their exemptions on their W-4 in order to have fewer taxes withheld. Take caution in such an endeavor as the IRS discourages such practices and federal law mandates that you pay quarterly income taxes if the amount being withheld is insufficient.
Surprisingly, this very brief domestic discussion changed my perspective on withholding tax completely. It is more beneficial to most taxpayers to allow standard withholding and receive a large refund at year’s end.
For a more detailed look at personal exemptions, visit the Internal Revenue Service’s page onPublication 501. (Personal Income Taxes)
Earlier this week, I discussed the practicality of determining how many exemptions to claim as it impacts tax planning. While that topic holds a great impact on your current paycheck and any annual refund you may expect in the end you receive the same amount of money over a 1 year period regardless of what decisions are made. There are a great many factors that can impact your taxable income: dependents, mortgage interest, marital status, investment income, etc. to name few. Those are all critical pieces but most individuals allow those chips to fall as the may seeking to impact their tax liability through other means. In my opinion, the most critical variable of your overall personal finances, as it relates to tax planning as well as current and future cash flow, is retirement investments. The decisions made investing for retirement hold a major impact on your tax liability today as well as when you begin taking retirement distributions later in life.
What retirement account is best for you?
The primary question is when do you want to be taxed? The answer…whenever your tax bracket is lower. Most of us expect our income to increase marginally each year for cost of living increases, promotions, investment returns, etc. If that’s the case, it is reasonable to expect your tax percentage will also increase over time. If that’s the case, you’d be better off paying your taxes now. The medium used to invest after-tax dollars for retirement is a Roth IRA (or Roth 401K if your employer offers such).
Essentially you invest money into an IRA (or 401K) designated as a Roth; unlike traditional IRA’s or 401K’s those funds are not tax deductible increasing your current year tax liability. The wonderful result of paying more taxes now are tax-exempt distributions during retirement (or after the age of 59 ½). In addition to paying a lower tax rate now than you would later in life, consider that your investments will grow over time due to increase in value, reinvested dividends, splits, etc. So not only are you saving taxes on the contributions, but also allowing you to generate earnings on those investments over the years tax-free!
However some individuals are in the top tax brackets now and will likely have a high net worth at retirement and who’s primary source of income will have ended at retirement therefore drastically reducing your overall tax liability. These individuals are currently seeking to minimize their current liability and will be able to afford to be taxed on future distributions. For those fortunate to earn on this level, it may be more advantageous to invest within a traditional IRA or 401K.
In this instance, your retirement contributions are tax deductible leading to a lower tax liability in the current year. However all distributions, principle contributed as well as any earnings on your investments are taxed when received.
Because the earnings over many years of investing will typically be significant, those opting for a Roth IRA will almost always, regardless of tax rate, benefit more as a result of those earnings being distributed tax free. I recommend anyone in low or middle tax bracket opt for a Roth IRA and gain the tax advantage in the future. Those in max tax brackets now should consider the following, invest retirement funds in a traditional IRA which generates a tax deduction in the current year. Use the tax savings from that deduction to invest in a Roth IRA allowing a portion of future distributions to be tax free.
Note that Roth contributions are capped at $5,500 per year (for all individuals under the age of 50. Those over 50 may contribute $6,500 under the “catch-up” rules.
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