A high tax withholding rate to force savings is a bad strategy

Share with others:


Print Email Read Later

Americans love getting a tax refund, so much so that many people intentionally have too much money withheld from their paychecks all year just so they end up with a fat refund check in the spring.

In recent years, the average federal income tax refund for individuals has been around $3,000, according to the Internal Revenue Service. That means households on average gave the government an extra $250 a month to hold, interest free.

Some people say they use federal withholding as a forced savings plan, contending they aren't disciplined enough to save on their own.

So what's wrong with that?

The biggest problem is people are giving up control of their money, said Gail Cunningham, public relations manager at the National Foundation for Credit Counseling.

"It's a forced savings plan that does not allow any flexibility on the consumer's end," she said.

People often run behind in their bills or need emergency cash when an unexpected expense pops up such as a big car repair or medical bill. A reserve fund could pay for the expenses.

"If you have an extra $250 a month, it could be the difference between financial stability and financial distress," Ms. Cunningham said. "Many people who receive an income tax refund don't realize that Uncle Sam is simply giving them back their own money, without benefit of interest," although with savings rates in the tank, the lost interest doesn't amount to much these days.

Still, instead of handing your money over to Uncle Sam, a better strategy is to use the cash to fund an emergency savings account, said William Strunkel, founder of Strunkel Tax & Accounting in Pittsburgh.

To make it easier to set the money aside, many employers with direct deposit allow employees to split their paychecks and have the money deposited into separate accounts, Mr. Strunkel said.

Having a second account lessens the temptation to spend the extra cash, say on eating out, he said.

Ms. Cunningham advocates a three-step program for breaking the tax refund habit.

Step one is to get a jumpstart on an emergency fund by plopping this year's refund into a savings account instead of spending it.

Next, raise W-4 federal withholding allowances so less money comes out of every paycheck.

"A lot of people think they can only adjust withholding once during the year," Ms. Cunningham said. "You can adjust any time you want."

Of course it's important not to over-adjust allowances and end up owing the government a bunch of money with no means to pay.

The IRS has a worksheet on its website for calculating the right level of withholding. Visit www.irs.gov and search for "withholding calculator."

The third step is to responsibly allocate the additional money each month from the larger paycheck.

"You don't want to get the money and blow it," Ms. Cunningham said.

The top priority should be keeping living expenses current, such as mortgage payments, rent, utilities and insurance premiums, she said.

If a savings account has to be tapped for an unexpected expense, replenish it with the following month's check.

The three-step system "stops the dependency on the income tax refund by establishing savings and providing money each month to keep a constant level of financial stability," she said.


Use that tax refund wisely

With the average federal income tax refund expected to be around $3,000 this year, Kiplinger's magazine recently came up with 10 ways for putting that money to good use.

• Rebuild your emergency fund. Save the money for unforeseen expenses or a disruption in income. Experts generally recommend having at least six months worth of after-tax income set aside that you can access without penalty to cover living expenses in the event of job loss.

• Pay off credit card debt. Using your refund to pay off a balance with an 18 percent interest rate is like earning 18 percent on your investments.

• Boost retirement savings. You can contribute up to $5,500 to an IRA for 2013 tax-free. People 50 and older can contribute up to $6,500.

• Fund a taxable account. Use the extra cash to buy shares in a mutual fund or stock that you've been considering but perhaps feel is too risky for your IRA or not available in your 401k plan.

• Fill gaps in your insurance. For about $350 to $600 per year, you can get coverage for flooding from the National Flood Insurance Program. For more information see www.floodsmart.gov.

• Build college savings. Use the extra money to contribute to a 529 account.

• Help your kids save. Contribute to a Roth IRA to help your child save for the future. For details, visit www.kiplinger.com and search for "Roth IRA for kids."

• Prepay your vacation. Set aside money for vacation rather than using a credit card and paying interest continuing long after the trip is over.

• Invest in your home. Pay for small home improvements such as painting or sprucing up the yard.

• Give to others. If your financial bases are covered, consider making a tax-deductible charitable donation.

mobilehome - businessnews - yourbiz

Patricia Sabatini: psabatini@post-gazette.com or 412-263-3066.


Advertisement
Advertisement
Advertisement

You have 2 remaining free articles this month

Try unlimited digital access

If you are an existing subscriber,
link your account for free access. Start here

You’ve reached the limit of free articles this month.

To continue unlimited reading

If you are an existing subscriber,
link your account for free access. Start here