Comments: Getting a Tax Refund is Costing Americans Billions

Here are a couple of thoughtful comments from my post titled Getting a Tax Refund is Costing Americans Billions that I wanted to share with you.

First, this commenter gives some advice I can agree with when it comes to tax returns:

Having too much tax withheld and getting a refund early next year is not too wise. Many financial articles acknowledge this but almost none are specific enough in explaining how to avoid this situation.

Most people fill out a form at the beginning of the year called a W-4. This form asks you a series of questions and directs you to write a number of "withholding allowances" down based on your answers. The number of withholding allowances determines how much of an employee's paycheck is withheld in taxes. The average worker just answers the questions honestly and writes down the number as they are told. The dirty little secret is that the IRS calculates the numbers in such a way that if a person fills out the form as directed, they are very likely to have too much tax withheld.

The way to get around this problem is to simply claim more withholding allowances than the Form W-4 instructions tell you to. Many think there is a penalty for doing this but that isn't true. The penalty only goes into effect if your total tax payments during the year are less than both 90% of this year's tax and 100% of last year's tax. Your total tax due (after payments and credits) must also be at least $1,000 for a penalty to go into effect.

So my advice to most workers for 2006 is to look at form W-4 and answer the questions as you normally would but add at least one withholding allowance to what you would normally claim. You'll be pleasantly surprised at the extra cash in you paycheck.

I agree. Work to estimate your 2006 tax liability, put in a little fudge factor so you don't under-pay, then adjust your W-4.

Second, this commenter has an interesting thought on what COULD be done with tax refunds -- instead of letting the government keep them for a year:

Imagine if all of that money were going into 401(k)s instead. Sure, it wouldn't be available as a downpayment on a new car or to fund a vacation. Picture even half of that going into retirement savings. Of course, I suspect I'm preaching to the choir here.

Very interesting idea.

Yes, this second commenter is preaching to the choir. But, we like the sermon. ;-)

Comments

[Nick]

I finally stopped being lazy and updated my W-4 last week. So instead of getting a $6,000 refund again next year, I'll be seeing over $100 extra in my check each week! Still, I will kinda miss that feeling of getting a big chunk of cash back every year. I won't miss not being the one making the interest on that money, though.

[mshrout]

Another thing to consider, if withholding too much is causing a cash tight person or family to use credit cards instead of being able to pay as you go, or building an emergency fund.

[Anon]

There's another aspect of what Nick did that's worth noting. The W-4 doesn't tell you how much will be withheld from your paycheck based on the numbers you supply. Of course that's because it depends on your income as well as the number of allowances. However, it is often easy to estimate your approximate taxes based on the previous year's taxes. One thing that I find brightens my outlook after signing my taxes forms and mailing them off is to adjust my withholding for the current year.

Things happen. You won't have the exact numbers for your tax bill until the books are closed for the year. However, we re-examine our withholding a couple of times to try to hit very close to the mark. Typically, we do it right after the taxes and again at the end of the 3rd quarter. A perfect year for me is one in which I owe $50 in April.

[AtlHeel]

The IRS withholding calculator is much more helpful than using just the W4 paper forms. You can factor in a little fudge factor in these numbers. The nice thing is that it estimates what you owe or refund based on current withholding and if you change your withholding.

http://www.irs.gov/individuals/article/0,,id=96196,00.html

Also...don't forget to change your state withholding (if applicable). Although the impact on your paycheck may be smaller, it still factors in to your year end number. I have gotten pretty good with my federal withholdings, but have always ignored the state. I just changed mine for the first time and I am now getting an extra $20 per paycheck.