Back in May 2012, I quit my first ‘real’ job, and I started working at my current company on the last day of July. During those two summer months at home, we were blessed with the delivery of our first child. Once I returned to work, I was greeted with endless forms that generally accompany the first day at any new job. One of those forms took on some new significance now that we were a family of three: the W-4.
Hopefully any of you who have had a job are familiar with a W-4 form. In a nutshell, employees use the form as a means of telling their employers how much money should be set aside from each paycheck for Uncle Sam (and maybe your state gov, too) by selecting a number of allowances. I’m not going to get into the nitty gritty of IRS tables and allowances, but you can think of it like this: more allowances = more money in your paycheck and less set aside for taxes.
Most financial advice and the form itself (it is usually set up as an IFTTT exercise) aim to have the amount withheld equal your eventual, annual tax obligation, or just a little more to to avoid owing anything. By this convention, I should have increased my exemption by one at the new employer because I now had another dependent and would be able to claim an additional dependent exemption come tax time (search for ‘dependent exemptions’ and ‘child tax credits’ to learn the difference). Instead, I chose to keep my exemptions the same as before.
What does all this mean? Every paycheck I let my employer set aside a little bit more than necessary for Uncle Sam. I don’t lose that money forever; instead it comes back to me each year as an increase to my tax refund. Why would I do this? I look at it as an artificial constraint that forces me to save and live below my means. I give up a little flexibility in the short-term for a nice little payout later.
I already know what many are thinking as they read this: “Whoa, whoa, whoa, hold up. You’re just giving the IRS an interest-free loan?! You should take that money during the year, invest it, and you’d come out ahead.”
I get it. This is going to go against the grain for a lot of people. From a purely mathematical/financial perspective, yes, it probably isn’t the most efficient use of my money. Then again, personal finance isn’t a purely mathematical exercise. As much as I’d like to be a perfectly rational, emotionless robot when it comes to spending, I just don’t work that way. Life doesn’t work that way.
Here are parts of my rationale:
Splurge Risk. It might sound counter-intuitive to some, but I am generally more judicious when dealing with larger chunks of money all at once rather than an increased trickle along the way. If we’re talking a difference of $100 in each paycheck, then I’m sure life will find a way to suck that $100 out of my account every few weeks (dang Amazon!). Then again, if I’m getting an additional $2,600 ($100 x 26 bi-weekly pay periods) in my tax refund, then I’ll more carefully plan out how/where to use it. Some might argue that I should be able to budget that extra $100 appropriately. Should I? Yes. Do I? Not always.
Investing. Going with the example above, if I had the discipline to invest that extra $100/pay period at 8% (optimistic?) over the course of the year, then I would be coming out ahead by only $102.51 at the end of the year (and that is before any capital gains taxes). What if my return is less? Or what if the market goes down? This just isn’t enough upside to rationalize subjecting myself to not only investment risk, but also my own spending risk.
Fort Knox. This is the ultimate set-it-and forget-it savings strategy. By having Uncle Sam hold my money, there is no way I can get it back until I file my annual tax return. Yes, you can amend your W-4 mid-year to alter your exemptions, but it isn’t something you are going to be doing on a regular basis. Having this money outside my control is the ultimate protection from myself.
If you are living paycheck to paycheck or don’t even have a small emergency fund built up, then I would not suggest this savings strategy for you, as it purposefully limits your financial flexibility. If you feel you are doing at least OK but looking for additional ways to save or prevent overspending, then this could work for you. It is a psychological play more than a mathematical one.
Ok, but how do I do this? First of all, this is savings advice, not tax advice. If you just want to give this a try right away, you can amend your W-4 at any time. I like to save these kinds of adjustments for the new year, but that’s just a preference. If you are looking for less shock to the system, you could wait until you get a raise. By decreasing your exemptions around the time of a raise you could keep your take-home pay similar and still end up with an increased refund. My experience of adding a dependent is probably the easiest. Some companies will automatically adjust your payroll when you add a newborn to your health insurance plan, so you may have to be proactive and check your status at work.
But what if I don’t have kids or if I’m single? Again, not tax advice here, but generally speaking, the average single worker is taking at least one exemption, and a married, childless couple will probably have at least one or two between them, so there is probably room for you to make some changes.
Anyone else trying to maximize their tax refund?