For a lot of people, the weekly paycheck is “take-home pay” because home is the only place they can afford to go with it.
They can’t go out, they can’t spend it on anything much beyond their bills, and they can’t save enough of it.
Surprisingly, however, almost three in four American households are missing out on a means of increasing their take-home pay.
They are paying too much in withholdings to the Internal Revenue Service.
Now is a good time to review your withholding strategy and adjust it to boost your take-home pay before the end of the year.
According to the IRS, 73 percent of all taxpayers get a refund. Some people use it as a savings or spending strategy, a way to stockpile some cash that they might not otherwise squirrel away. Others see it as an interest-free loan to Uncle Sam, and a dumb way to gather financial acorns.
“You have to decide what type of person you are and whether you could better use the money somehow now, or if you want to use the tax payment mechanism as a form of forced savings,” says Michael Carona, a partner at Coopers & Lybrand in Boston. “Tax professionals will tell you that one answer is right, but a lot of people don’t want to take that advice.”
What most tax pros would suggest is a strategy that results in either no refund or taxes due come April. In the meantime, you can put the money to work or create your own savings plan.
“People don’t realize how much they can help themselves by cutting back on their withholdings and giving up their tax refund,” says John Oteri, tax partner at DiPesa & Co. in Boston. “When you look at the possibilities, you would probably want to put that money to work now. Yet a lot of people don’t do it.”
Let’s examine those possibilities.
To get a rough estimate of the amount you could add to your take-home pay, look at last year’s refund, then divide it by the number of paychecks you would receive in a year. A $780 refund check, therefore, amounts to $15 in overwithholdings per week.
That might not seem like much money, but it adds up when put to good use. The bigger your refund, the more you are losing from your monthly cash flow.
If you like the forced savings idea, for example, you could have the money redirected from your paycheck into a bank, money market or mutual fund account. Many employers allow direct deposit of all or a portion of a paycheck to one or more financial institutions.
The benefit of doing this, therefore, is that the money grows interest, rather than the mold it picks up during its stay in Uncle Sam’s pocket.
The money can become your emergency funds, there to help bail you out of trouble.
Likewise, that extra money can go to debt reduction. I know one colleague who likes a big tax refund check so she can “pay for a vacation that I don’t have to put on my credit cards.” But the credit cards are accruing interest charges now; she’d be better off financially trimming debt regularly, thereby reducing the interest charges on her outstanding balance, and then using the card for the vacation (provided she doesn’t outspend her savings).
Many people view their refund as found money, a wad of cash they can blow on something fun. Yet these same people feel as if they are living paycheck to paycheck. They might get more mileage from their money if they didn’t let it build up into a cash stash.
That’s why this is a good time to check your withholdings. Changes made now and, in effect, through the rest of the year can be a good test for how well you will use any windfall you might receive, whether you are better off sticking with the big refund or adding it to your take-home pay.
Under any circumstances, experts suggest checking your withholding pattern whenever you have significant changes in income (pay raises, big capital gains, a second job, etc.), itemized deductions (such as medical expenses or costs related to the purchase of a new home), and home life (marriage, divorce, birth of a child or the loss of a dependent when a child strikes out on her own).
You can check your withholdings on the IRS worksheet that most employers offer. The worksheet and a more complete explanation are also available in IRS Publication 919, “Is My Withholding Correct?” The publication is available by calling 800-829-3676.
Essentially, the process boils down to looking at your projected withholdings against your estimated earnings and the taxes you will owe on your income. The idea is to keep the gap narrow, or even negative.
To avoid underwithholding penalties, you must withhold an amount equal to 100 percent of what you owed last year, or 90 percent of what you owe for the current year. (The one exception is if you owe less than $500 in taxes, in which case there is no penalty for underwithholding. Effective next year, that low limit will rise to $1,000 in taxes due.)
“There is nothing wrong with underwithholding, so long as you are prepared to pay the taxes next April,” says Carona. “I’d rather have the money working for me and be prepared to deal with it next year. Where people get into trouble is when they don’t withhold enough, and then don’t save the extra take-home and wind up having a hard time paying their tax bill.”
Once you have the basic information you need to calculate withholdings accurately, change your W-4 form with your employer, arranging to take more (or fewer) exemptions in order to withhold a correct amount. (If your projected withholdings show a potential tax bill, consider increasing the payout or plan to pay up next spring.)
Most employers will help you determine the appropriate amount of withholdings, and the right way to adjust your set-asides; if not, trial-and-error–modifying your W-4 until withholdings move by the amount you need to get into balance–will work, even if it drives the payroll department crazy.
“If you went up to people and said: `Here is some money. Would you rather let the government hold it for a while or use it now to pay for food, shelter or savings,’ it would seem like an obvious choice,” says Oteri. “When you think about it that way, it gives you some motivation to go and try to make your withholdings right.”
