I like getting a refund check from the tax man during tax season. Because of that I always get chastised by somebody at this time of year telling me I’m crazy.
Indeed, most income tax experts advise us to take advantage of a tax-planning strategy that provides more take-home pay over the course of a year as opposed to a big refund once a year. The conventional wisdom is that it’s better to increase your federal income tax withholding exemptions, which then results in higher take-home pay, which can then be invested in an interest-bearing savings account.
The fact is, most of us don’t get that much money back from Uncle Sam anyway to make much of a difference. For this reason I’ve always maintained that it is much better for me to get the tax rebate at the end of the year. If you carry no credit card debt and have your bills under control, then it is most likely true for you too.
How much extra money do you stand to lose each year by letting the tax man hold it?
According to the United States Internal Revenue Service, the average US federal tax refund in 2007 was $2,345. Using that figure, let’s see what the average person would earn if they adjusted their withholding allowances on their W-4 form to the point where their refund was actually zero.
If you placed $2,345 into a one-year CD at the recently advertised rate of 2.38%, it would earn $56.31. That’s not much to write home about. In essence, that $56.31 represents the opportunity cost of having a forced savings account.
Unfortunately the additional money received by increasing your exemptions is spread out incrementally across the entire 52 weeks, which would force many people to a more traditional savings account paying a much lower interest rate. Of course, on the positive side, that also means that the opportunity cost also decreases.
How much lower? Wachovia was recently advertising their “Premium Savings Account” to potential customers, asking them to save with Wachovia and “watch your savings grow!” That sounded good to me, until I did the math. Folks with less than $5000 to deposit were being offered an interest rate of 0.05%. Over the course of the year, that would return roughly 68 cents.
If that’s Wachovia’s version of premium, I’d hate to see regular. And does Wachovia realize we’d have to live to the ripe old age of 10,000 to actually “watch our savings grow!”?
Acorns transform themselves into mighty oaks in shorter time; maybe Wachovia could hand one out with every new account, encouraging customers to also “watch your acorn grow!” If not from the savings account, at least they could see some tangible growth on their acorn before they died.
Claiming fewer tax withholding exemptions is a great way for many people, especially those that are undisciplined, to maintain a forced savings account that offers a guaranteed windfall each Spring that can be used to pay for big-ticket purchases and/or aid long-term household financial strategic planning.
True, if you have high-interest credit card card debt, or are having trouble paying your monthly bills, then by all means increase your withholding exemptions so you can take advantage of the extra cash.
Otherwise, there’s no significant advantages either way. That is, unless inflation comes roaring back with a vengeance. Or you plan on living a long, long, long time.
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