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 dough back from Uncle Sam to make a difference. For this reason I prefer to get a tax refund at the end of the year. If you carry no credit card debt and have your bills under control, then you may want to consider getting a refund too.
How much extra cash do you stand to lose each year by letting the tax man hold it?
Well, in 2014 the average US federal tax refund was about $2,831. With that in mind, let’s assume you adjust your withholding allowance on your W-4 form to avoid a refund. If you placed that $2,831 into a one-year CD — where rates currently average about 1.1% — your cash would earn $31. Big deal. In essence, that $31 represents the opportunity cost of having a forced savings account.
Here’s the rub with CDs: The additional income you receive by increasing your exemptions is spread out incrementally across the entire 52 weeks. So most people put that cash into a traditional savings account paying a much lower interest rate instead. How much lower? Well, if you’re not a careful shopper, today you can easily find banks offering just 0.01% interest! Over the course of the year, that would return … 28 cents. I know.
The funny thing is there are countless banks and credit unions that still use the ubiquitous catch phrase “Watch your savings grow!” Frankly, an acorn transforms itself into a mighty oak in far less time. In fact, with the paltry rates banks are offering today, savers have to live to the ripe old age of 10,000 before they’ll see any results. But I digress.
Claiming fewer tax withholding exemptions is a great way for many people, especially those that are undisciplined, to maintain a forced savings account. It also offers a guaranteed windfall each spring that can be used to pay for big-ticket items or help meet long-term household financial strategic planning goals.
True, if you have high-interest credit card card debt, are having trouble paying your monthly bills, or expect an extremely large tax refund, then by all means increase your withholding exemptions so you can take advantage of the extra cash all year long.
Otherwise, there’s really no significant advantage either way. That is, unless inflation comes roaring back with a vengeance. Or you plan on living a long, long, long time.
Photo Credit: frankieleon