A Reader Asks About Tax Withholdings And Savings

Recently, a reader of The Simple Dollar contacted me with an interesting question about tax withholdings:

With the tax year over, we get to see what we owe the IRS and the State in taxes. Normally we have our employers withhold amounts and send them to those entities, where they sit doing nothing. Alternatively we could withhold nothing, and instead set that money aside in (for example) and HSBC Direct account. This could potentially be a lot of money gaining interest for you, rather than sitting in the government’s coffers doing nothing.

Obviously the trick is to actually set that money aside and not spend it, and then to set aside at least the correct amount. I’m pretty sure I’d be safe using the previous year’s taxes due as a good estimate. Just wondering what you and/or your readers might think of this.

If you look at this situation with some huge blinders on, then my reader is absolutely correct. You can keep your own withholdings, invest them yourself, and then just write a check for your income tax. Look at the federal taxes withheld on your last pay stub for the previous year; you could easily earn another 2.5% on that amount for your pocket before you even write a check for taxes.

But let’s take the blinders off and realize the truth: you are opening yourself up to a huge amount of risk by doing this. How?

You’re relying on your own calculations of what you’ll need for your income tax. You could use your previous year’s amount as a guideline, but the truth is that if there are income tax changes or changes in your own income, that amount is going to change and could change drastically. If you make a mistake here, it could be a big problem come tax time.

You’re taking money that is effectively untouchable and making it easily accessible. Suddenly, that money which you couldn’t touch before is suddenly sitting there in a savings account. Thousands of dollars. Can you resist the temptation to withdraw a little for a big date, or for a new refrigerator? Suddenly, you find yourself on tax day without enough money to cover the account.

The IRS is not impressed if you “don’t have money” to pay your taxes. The penalties for messing this up are severe: the IRS isn’t a patient and friendly organization and they will go after you if you don’t have the cash to pay.

These are significant risks that you should never overlook when considering such a thing. Because of these risks, I don’t recommend following this plan; you take a situation where your taxes are covered and turn it into a situation where there is risk. Given the penalties, that risk simply isn’t worth it.

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  1. Lee says:

    Of course, there is one other big problem. The US tax system is designed as a “pay as you go” system. If you don’t periodically withhold your taxes you are expected to make quarterly “estimated tax” payments. If you do neither, then you must pay a penalty to the government if the amount you have to pay exceeds $1000.

    There can be some exceptions to this and one is if you are making a lot more money one year than the year before you only have to make sure you pay as much as the previous year to avoid the penalty. But that is a rare occasion to make some extra interest.

  2. Luke says:

    Lee is right. If you opt not to withhold Federal taxes from your paychecks, you must make timely and sufficiently calculated quarterly estimated payments. This still leaves you open to some risk, but it is hardly worth it as the money you aren’t paying in withholdings simply has to be remitted every quarter. It really doesn’t have much chance to sit in your interest bearing account.

    The tax code was not originally set up this way, but there was such a large problem with compliance that the “pay as you go” system was put into place.

    I personally think that if Americans were allowed to save the money themselves all year long and then remit the full Federal tax liability to the IRS on April 15th that we would have the threat of revolution on our hands, which depending on who you talk to may be exactly what we need.

    As a tax accountant, it blows my mind how many people I speak to who are under the impression that they “don’t pay taxes” because the receive a refund on their return every year. They don’t seem to realize that they still pay a significant amount in taxes.

    Regardless, I personally think we need a huge, sweeping tax reform.

  3. CF25 says:

    IMO, the “withhold the minimum, high-interest savings, pay at the end” is better than witholding too much and giving the government an interest-free loan.
    If you get a $1500 tax return, you could have been earning 2-5% on that throughout the year.
    Different strokes for different folks though

  4. frank says:

    Don’t forget about the 110% safe harbour clause. If you withold 110% of last years tax bill, even if you owe money in the coming year, you will not be subject to additional fees and interest.
    Of course, this is only material if you think that your tax bill would be substantially different from the year before.

  5. HC says:

    For the vast majority of filers, withholding isn’t binary.

    When I thought I was going to be short last year, I simply adjusted my withholding allowance by adding on $5 a pay period to my 2 exemptions. Then, when I realized I had forgotten that my health insurance premiums weren’t taxable, I stopped sending the $5 and upped my exemptions to 3. I’m still getting a refund, but a much smaller one than I would have otherwise (and yes, I did save the difference).

    This year, I’ll have a smaller student loan interest deduction, so I dropped my exemptions back to 2. Granted, not every HR system makes it as easy to adjust one’s W-4 as mine, but it’s still not that complex.

    I’d say if people are willing to use the withholding calculator on the IRS website twice a year, then they should be able to make adjustments to reduce their refund without dealing with quarterly payments or potential penalties.

  6. BR says:

    I adjust my withholdings throughout the year to do what HC says. According to my employer’s tax person, I can go up to 10 withholdings without my employer contacting the IRS. Beyond that, they are required to contact the IRS. Last year, I paid $80. I’ll get it to zero one of these years.

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