Taxpayer asks:
Dear Taxgirl,
I’ve heard the old saw about how a big refund is basically an interest-free loan to Uncle Sam.
What I was wondering is if I could flip that: minimize my automatic withholding (increase exemptions on my W-4) and stash that money into a high-interest savings account – have 15% of my income go there automatically – which I never touch. Then when tax-time comes, I could pay out of the account what taxes I owe, keeping the interest for myself (or next year’s taxes).
Do you see any obvious stumbling blocks (aside from self-discipline)?
Taxgirl says:
I think most tax professionals would agree that keeping more of your money from your paycheck during the year is a savvy tax planning move – especially if you can stash some away in an investment or savings account. You’re absolutely right, though, that you have to exercise self-discipline to pull it off: It’s one of the reasons that many taxpayers opt to keep their “savings” in the form of a fat refund check.
However, you have to exercise a little tax savvy along with that self-discipline. If you owe when you file your federal income tax return, you may end up paying an underpayment penalty. And worse: penalties may also be subject to interest. Depending on your situation, that could offset any benefit from holding onto more of your paycheck.
To avoid an underpayment penalty, you typically must owe less than $1,000 in tax after applying your withholding and refundable credits, or your withholding and estimated tax payments must equal at least 90% of the tax for the current year or 100% of the tax shown on the return for the prior year, whichever is smaller. Some exceptions apply (this is tax law, of course).
To make estimated tax payments, figure your estimated tax using the worksheet on the federal form 1040-ES (downloads as a pdf). For estimated tax purposes, the year is divided into four payment periods, about once every quarter (usually April 15, June 15, September 15 and January 15). Watch the dates carefully: if you don’t pay on time, the penalty may apply.
To change your withholding, you can give your employer a new form W-4 (more on form W-4 here). It’s worth noting – especially in light of tax reform changes – that you cannot give your employer a payment to cover federal income tax withholding on salaries and wages for past pay periods or a payment for estimated tax.
Bottom line: If you can adjust your withholding and you have the self-discipline to pull it off, keeping more of your check throughout the year can be a good tax planning strategy. But if you can’t manage your withholding or you know that you’re likely to blow any extra cash in your check before you pay off your taxes, it may be best to err on the side of letting the government keep a little as you go (out of sight, out of mind). Not sure how the numbers will look? Your tax pro can help you run the numbers.
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Before you go: be sure to read my disclaimer. Remember, I’m a lawyer and we love disclaimers.
If you have a question, here’s how to “ask the taxgirl.”
