Should You Adjust Your Income Tax Withholding?

For many people, tax season brings the hope and expectation of a refund. Those refunds bring the opportunity to pay off lingering bills, plan a much-needed vacation, or bolster depleted savings. But is planning for a refund the best angle to take come tax time?

For years, financial experts have advised people to adjust their withholding so that the amount being taken out of their paychecks is limited to whatever amount gets them as close to zero on their tax returns the following April. “Why give the government an interest-free loan when you could have more money in your account throughout the year?” they ask. Like so many pieces of financial advice, this strategy works for some, but not for all.

It boils down to whether you want to have more available cash on hand throughout the year by claiming more withholding allowances or plan for a tax refund by claiming fewer allowances (and thus, having more money taken out of your paycheck).  We’ll outline the pros and cons of each, so you can pick the withholding choice that works best for your unique needs.

 

Saving vs. Spending

Most American households have less than $1,000 in savings.  It takes a certain amount of discipline to save money regularly (automatic deposits into a savings account are great ways to stick to a savings plan), and unexpected financial emergencies can cut into “rainy day” funds with little to no warning. Additionally, it’s much easier to spend money if it’s readily available.

Instead of looking at high withholding as providing a loan to the government, many purposely use it to reliably put money aside. Often, tax refunds are used to pay off debt, make larger purchases like a family vacation or bolster a saving’s account. It can be easier to adjust to slightly smaller paychecks throughout the year than make the conscious effort to save money each month or pay extra toward debt.

Why not put that money in a savings account and generate interest? While certainly a valid approach, saving’s accounts don’t tend to generate high interest rates. Is it worth an extra dollar or two to let Uncle Sam set the money aside for you?

 

Rainy Day Funds

Naturally, if you are getting more money each paycheck and regularly save money throughout the year, then more money is readily available for financial emergencies. If your money is tied up with the government, it can’t be taken out whenever an unexpected expense occurs such as your car breaks down or a trip to the emergency room. 

By setting up automatic transfers of a small amount of each paycheck to a dedicated savings account, the money is available when you need it. Of course, if your withholding levels are too low, then you might owe money to the IRS in April and your savings could quickly be eaten up.   

 

Pay Down High Interest Debt Instead

When you look at your whole financial picture, you may find that there are other ways to make your money work for you.  Instead of using Uncle Sam to force you to save, you can allocate the extra money in each check to paying off debt.  Paying off high-interest debt faster, will reduce the amount of money paid in interest over time and the money saved may amount to more than you would have received with a tax refund. This is obviously less glamorous than using the refund for a family trip, but with less debt, paying for those trips becomes easier.

 

Unexpected Taxes

The tax laws can be confusing, so minimizing your withholdings too aggressively could leave you with a surprise when tax day rolls around. Some circumstances make it difficult to anticipate how changes could affect your tax payment or refund. While it’s certainly easy to tweak your withholding from a regular employer, according to a recent study, 44 million Americans have side jobs to generate extra income. You might be comfortable with the withholding allowances on your 9-to-5 employment, but if you aren’t saving some money from your side hustle to pay taxes on that income, you may be surprised come tax time.

 

Finding the Right Approach

There is an art in managing withholding. While most of us know what we want to achieve and approach taxes with that in mind, it can be difficult to chart the best path. It comes down to what works best for you. Are you able to stick to a savings plan? Do you have high-interest debt you should pay down sooner rather than later? Does it make sense to adjust to a smaller paycheck and use the refund in ways that best suit your needs or wants? If you understand the pros and cons of each strategy and plan accordingly, you can navigate this tricky financial situation and make the system work for you.