Most of us pay taxes as part of our paycheck each month, as Uncle Sam mandates it to be. For many people, this means overpaying a little bit each month “just to be safe”, and getting a nice fat tax refund the following year (We ourselves got $1,046 back this year). But, as others have pointed out, this is the equivalent of giving the government a interest-free loan. I don’t know about you, but I’d much rather take an interest-free loan myself. So instead, why not withhold as little as possible, invest the money you would have paid out somewhere earning interest instead, and in April pay back the government what it’s due. (Similar to taking advantage of 0% APR credit card offers.) But how little can you pay?
First, you’d want to figure out how much tax you are supposed to pay this year. For this, the IRS has kindly offered us the IRS Withholding Calculator. Having your pay stubs and previous tax return handy will help you punch in the numbers. The calculator will estimate how much tax you should pay for 2005, and based on what you’ve already paid, tell you how many allowances to claim on your W-4 form and any additional amounts to withhold from your paycheck(s) each month. We are a dual-income no-kids family, so our tax bill is a bit heftier, and the calculator recommended 0 allowances and also $147 per paycheck.
Second, how little can you pay without having to pay a penalty at the end of the year? For this, I reference Topic 306 – Penalty for Underpayment of Estimated Tax at IRS.gov. I quote:
“Most taxpayers will have paid enough tax to avoid this penalty if they have paid at least 90% of the tax shown on the return for the current year, or 100% of the tax shown on the return for the prior year, whichever is smaller. However, if your adjusted gross income was greater than $150,000 in 2003, or $75,000 if you are married filing a separate return, the test is 90% of the tax shown on your 2004 tax return, or 110% of your 2003 tax, whichever is smaller. There are also special rules for farmers and fishermen.”
We make less than $150k, and the only thing I can grow is weeds, so for us personally it boils down to:
1. 90% of the tax to be shown on your 2005 tax return, or
2. 100% of the tax shown on your 2004 tax return
Based on the calculator, our estimated 2005 tax bill is $10,986. 90% of that is $9,900. We paid only $8,600 in taxes this year, as my wife only worked part of the year. So it looks like we’ll only have to pay $8,600 in taxes this year to avoid a penalty. I’m going to set 0 allowances for both of us and $20 per paycheck to bring it close, and review it in October to make sure.
Finally, is this worth the bother? Last year, I overpaid by $1,050. It looks like I am allowed to underpay this year by $1,300. If I divide this $2,350 difference into 12 monthly parts of $196, and invest it every month at 3% interest (est.) for a year will get me… $41. Not too exciting, but hey, it’s something. And it only takes a quick note to your HR dept to change your withholding amount.
(In addition, if you have any credit card debt or other loans with high interest rates, your payoff will be greater.)
If you’d like, go ahead and run the numbers for yourself. I know people who got $5,000 back this year, so in that case your savings would be in the hundreds of dollars and worth a look.
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The number of people who intentionally overwithhold just boggles my mind. Witness a guy I work with:
This past year he overwithheld federal taxes to the tune of $5000+. This, while receiving collection notices from two agencies regarding past-due medical bills, and also while his wife was out running up a $6k balance on a credit card about which he was unaware.
Brilliance in action, I tell you.
Fundamentally — you are correct that it is really not financially wise to give the feds an interest free loan.
But — emotionally — it is painful to write a several thousand dollar check at tax time instead of getting a few hundred back.
I try to withhold enough to get a little back.
I would also guess that there are quite a few people who “depend” on their tax refund. Some people are living “paycheck to paycheck” and simply don’t have the knowledge/drive/wherewithal to set aside money for savings on there own.
I like this idea. So, I’m looking at my 2004 tax forms, and I can’t make much sense of what I’m seeing, but it looks to me like I got back all the income tax that I paid. I guess my question is, what exactly should my note to HR *say*?
A lot of it depends on your current situation and how you are set up.
1) Amanda, you sound like you either made less than 7900 total gross wages last year, or you are a child who made less than 4800. (New for this year of 8,200 and 5,000 respectively.) This is the standard deduction of 5,000 (single) and 3,200 (dependency of self).
2) I can’t really go in tremendous detail about all the different aspects, but basically if you won’t meet those requirements, you should send in the W-4 (the form which you fill out) to HR and put “EXEMPT” on the line where it states it. This should stop you from withholding taxes — Make sure that you keep a good eye on it if you are getting close.
3) One thing that was left out in the article is that if you owed no tax liability for 2004 and were a US citizen or resident for the entire year you will not have to pay a penalty. Also, if you calculate your total tax owed on the 2005 return and have withholding, as long as the difference is less than 1,000 you will not have to pay a penalty.
I agree, this year was the first year that I really had to ‘plan’ on my taxes. I had a tax liability of 922 last year, and this year over 2,000. I had planned it pretty well, and paid a total of 975 or so. (So what he can keep the $50 I paid extra in the last month of the year – I wouldn’t have earned much on it anyways.)
Now, had my tax been 2,000 even and I paid 1001 I would be set under the rule of the difference would be under 1,000.
To get the form required (2210) to figure out if you owe (And while the IRS says ‘it can be complicated’ and ‘to let them calculate it’ I would strongly suggest that you do it so “Uncle Sam” doesn’t make a ‘mistake’. Even if you do not file the form (2210), I stress keeping a copy with how you figured things out. Below is a listed link to the 2005 form 2210 PDF that you can fill in and file. Just follow the instructions and if you do have to pay the penalty, than perhaps seek help from your local tax preparer.
http://www.irs.gov/pub/irs-pdf/f2210f.pdf
I would like to comment I enjoy this blog especially, because it can be even better than the 0% credit transfer – this will not hurt any credit scores — it’s simply called ‘tax planning?, which is completely legal!