Guest Post: A Simple Way To Give Yourself A Pay Raise (If It’s Right For You)

I recently came across an article stating the IRS has concerns that many individuals may not be withholding enough for taxes.  While it is important to take an active interest in making sure your withholdings are appropriate, I feel we are focusing on the wrong issue.  I’ll admit, nobody wants a surprise tax bill, but blindly increasing withholdings to avoid a tax bill shouldn’t be the main focus.  The real question people should be asking themselves is; how much should I be withholding to achieve the best financial result for my family and I?

In other words, is it better to get a fat refund check or is it better to minimize or even zero out your withholdings so you can keep more of your money throughout the year?

When I was growing up, I heard people brag about how big their tax refund was, as if it was a badge of honor.  Get a couple grand back, and it meant you were pretty awesome.  They acted as if they just received a gift from the government or like they just cashed in a lotto ticket.  However, this couldn’t be further from the truth.  Your refund is a return of the taxes you overpaid to the government.  Actually, you made an interest-free loan to the government and they are simply paying you back.

The average refund in 2017 was $2,763.  The most recent data from the U.S. Census Bureau indicates the median household income in the U.S. was $59,039 in 2016.  So, basically what this means is that people on average are lending the government 5% of their gross annual income without receiving any interest for the loan.  Think about that for a minute.  Hopefully, it changes the way you think about your refund.

Now, imagine if you adjusted your withholdings to minimize or zero out your tax refund.  Instead, you have increased your monthly income by $233, which is 1/12th of the average annual refund (this may vary but keeping the math simple here).  Think about what you could do with that money.  Well, I’ve had a couple thoughts:

  • Save for retirement – let’s assume a 45-year old begins putting this money into a Roth IRA each month. If we assume a 6% average annual growth rate, this individual will have approximately $105,668 in additional retirement savings at age 65.  That adds a tremendous amount of tax-free assets to supplement retirement income!  One word of caution if you go this route. I would highly recommend creating a monthly automatic contribution to help you stay disciplined in your monthly savings.
  • Pay down debtaccording to a study by Experian, total credit card debt has reached its highest point ever, surpassing $782 billion. Another concluded the average American has a credit card balance of $6,375, up 3% from 2016. Considering these staggering numbers, do you think it’s wise for Americans that have high-interest debt to continue making an interest-free loan to the government?  Of course not!  They may be better served keeping more of their paycheck and using those funds to pay down debt.  Consider an individual already allocating $200/month to pay down their credit card debt of $10,000.  With an interest rate of 16.71%, it would take 87 months to pay off this debt.  Over that period of time, the individual would pay approximately $7,233 in total interest.  However, if this individual increased monthly payments by $233, the card would be paid off in only 29 months.  Total interest paid over this period would only be $2,149 for a whopping savings of $5,084 in interest payments.  That is significant!
  • Protection for your family – a large number of American households are underinsured. In fact, 7 out of 10 households only have enough life insurance to replace income for 3.5 years.  Of course, life insurance needs are going to vary depending on your situation, but ensuring your family is taken care of in the event of an untimely death is critical.  For those that need additional protection, they could use all or a portion of their refund to purchase adequate life insurance.
  • Current expenses – it may just be nice to have an additional $233/month! This could provide some much-needed breathing room in your budget.  One of the main things couples stress out about and fight over are finances.  Adding some additional dollars can reduce stress.  It could help pay for things like daycare (parents will feel my pain here!). Or how about just having a little more fun?  Take the spouse out for a date night or take the family on a mini-adventure.  Create some priceless memories.

If you could see yourself benefiting from at least one of these alternatives, you need to look into adjusting your withholdings.  Your first step should be to utilize the IRS Withholding Calculator. Most taxpayers will be able to use this calculator to determine a fairly accurate withholding amount.

However, it is important to seek guidance from a tax professional that can make sure you are claiming all eligible exemptions, or, if you pay quarterly, they can help determine more accurate quarterly payment estimates.  A tax professional can also make sure you are not withholding too little.  Obviously, this can help avoid a large tax bill, but it can also help avoid potential penalties.  If you owe more than $1,000, you could face a penalty for underpayment of taxes.  This penalty essentially takes the form of an interest charge on the amount owed.  In addition, a tax pro will be able to help you change withholdings on various items such as W-4 wages, Social Security benefits, pension income, and IRA withholdings.

Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities. Please see Terms of Service at bottom of this page for full disclaimers and terms of service.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual, nor intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Hypothetical examples are for illustrative purposes only and do not represent any investor situation. Your results may vary.