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?
I’d much prefer to have my tax refund be $0. After all you’re basically giving the IRS an interest free loan. That’s at least worth 1% of whatever your refund is. So I would just opt for setting up a smaller withholding number because I’m able to handle my finances myself better than they will
I get it. The interest-free-loan part is a hard sell for some. If you are saving as much as you’d like and are never tempted to mis-use those savings, then keep on keeping on.
We do the same thing! I know I could save this money elsewhere, but I totally stand behind your reasoning. If the money never makes it to your bank account in the first place, you’re not tempted to spend it.
Exactly. As much as I would like to execute my financial plans exactly as I plan them, it just doesn’t happen that way.
I understand that it is more of a psychological hack to “prevent” you from spending the money, and if it works for you, great.
Other hacks would be to put it into your 401k (assuming you haven’t maxed that out yet, but if you have, you are probably beyond this type of hack) if your plan for the money is long term savings. It would accelerate your long term savings while also reducing your current year taxes, double hack!
Or deposit the money into a separate savings account that you have for your emergency fund/mid term savings/other fund. If you need the mental barrier of not seeing the money in your spendable account, then open separate accounts for day to day spendable money, and another account for your “don’t touch” money.
The biggest area I think you are short changing is the investing rationale. You should not be putting money you plan to use in the near future in stocks, so looking at one year gains is too near-sighted. Money you invest in stocks should not be touched for 15 plus years, so present the example as what you are earning over a longer time period. $1000 @ 8% after 15 years will give you $3,172. Otherwise, your “splurge risk” and “fort knox” rationale are good reasons to hide money from yourself.
As you said, it’s “personal” finance for a reason, so choose the best hack that works for you.
We max out our retirement accounts and our HSA. Additionally we do have some funds being funnelled to a savings account that we try not to touch. Unfortunately, even those funds end up getting hijacked all too often. Hence the additional step to restrict additional funds.
I definitely wouldn’t recommend this kind of strategy for long term savings. Just one more way to save a little each year and sort of force us to live below our means. Definitely a psychological play that many may not need/like. Thanks for your thoughts.
Back in the day when savings accounts would pay 3-5% or more (you know, like 10 years ago), then it made perfect sense to aggressively pursue a strategy to get little or no money back. Now that the Fed has destroyed the concept of saving money for the average household, there really is very little incentive unless you plan to take the money and invest in riskier assets.
I agree the incentive to stash in savings accounts has been almost wiped out. But even more aggressive assets wouldn’t be that exciting for such a small amount of money and for such a short amount of time. It would obviously depend on how much extra is being withheld, but if you look at my example of $100 every two weeks even at 8% the notional return isn’t very exciting. This is only a single year savings strategy, and then at the end of the year you HAVE to do something with it. Interest can have a powerful effect, but at 3-5% it’d take quite a while to see big gains.
This is my plan, as well. When I started my current job, I put myself down as single on all the tax forms, despite being married with one kid. The tax rebate as forced savings ends up going directly toward a major financial goal — otherwise, it’d be far easier to fritter it away every 2 weeks on extra dinners out or small splurges.
Bingo. Another way I look at it beyond forced savings is an additional protection against lifestyle inflation–it forces me to live on less. That’s partly why I suggest people make a change when a raise comes, to help prevent them from succumbing to spending that new found extra moolah. Sounds like you’re ahead of the curve. Very nice.
But why can’t you just set up an automatic transfer to savings of that money with each paycheck? That way it would go straight to savings and you wouldn’t fritter it away.
Or you even increase your retirement savings with that. Or add it to an HSA if you have one. That way you would be decreasing your tax exposure as well.
I also do as you suggest with a savings account, but the extra in my tax refund is better protected (fort Knox ‘ish) from my own splurge risk as noted in the post. In the past I’ve ended up raiding that savings account earlier than I had initially wanted.
Retirement accounts are currently maxed out as well as our HSA, so this is trying to save in addition to those.
Totally agree with TARYNKAY. If you’re afraid of spending it now, then you’re only delaying that spending until you get the refund. Rather, you could work toward maxing out your 401k, HSA, IRA(s) and watch compounding growth work for you. That would be a real savings strategy.
I disagree on the eventual delay of sub-optimal spending. If I have an extra hundred here or there each month then I’m more susceptible to spending it than if I get that lump sum at tax time. Obviously this is my own issue, and it may be different for others.
We currently max out retirement accounts and our HSA in addition to this.
We do this too. The one year we didn’t do it was the year we had to pay in. Never again! It is much easier for me to save when we get that big chunk of money in the spring. Or else we use it for necessary big spends like replacing an appliance or other house stuff. So many people say that I am foolish yet I never feel a money crunch when emergency spending strikes.
Oooh, the thought of having to pay up at tax time makes me cringe. I would much rather play it safe than risk having to pony up at the very least.
I think the idea of being taxed is taken too seriously, because like you say, you’re getting the money back eventually, and it is like a nice little gift that you’re being forced to give yourself. Great ideas here, and glad things worked out.
Glad you like the idea. I really like getting that little extra each year; it certainly puts a smile on my face.
I do the same thing! I love that big chunk during tax season. I realize I could get it monthly but I really like that “bonus” even though logically I know it was mine all along. 🙂
So much focus is put on the math behind personal finance decisions, which is a good thing. Unfortunately, psychological benefits often get undervalued because they are hard to quantify.
We are in the opposite situation where we try to pay our taxes early vs lump sum at year end. We have a nanny – which means I pay her taxes plus my share of her employment taxes when I file my federal taxes. Yes, I could put this money aside every week (and earn interest) but it is much easier to buff my deductions so that I owe less at year end. I have peace of mind that I am not going to get a huge bill at the end of year. It just “hurts” less mentally . In addition to this we have variable income (due to a rental property) which has made us get some nice returns and some not so nice returns/bills. Again, I would much rather pay to much through out the year than receive an unexpected bill at year end.