Welcome back. Congratulations on getting your taxes done. Now what??? By popular demand (100% of commenters asked a variant of this question) I am following up my 3 part series on Federal Income Taxes with some information that might help you with that frustrating question: How many withholdings should I claim on that W-4 document dealy that my employer makes me fill out?
I could end the blog post here by answering “it depends”. But I’m guessing that you would question the usefulness of this blog post, so let’s try to dig in to something that is actually useful for you.
Tip #1: If you still have your most recent taxes handy, use this tool from your friends at the IRS:
I hope it’s pretty self-explanatory. Do it right after you get your tax return done, while the terminology and such are fresh on your mind!
Tip #2: If you got a big check last year, and don’t expect major life changes (birth of a child, significant change to income, etc.), add a withholding and see how it affects your paycheck. This is a simple, safe change. And then you can do some simple math to see how it will affect you.
Old federal income tax taken out, $51
New federal income tax taken out, $31
CONGRATULATIONS! You just got a $20 per paycheck raise by adding a withholding.
Number of checks left this year: 21 (in this example, you get paid twice a month and you’ve received 3 checks so far in 2015)
Reduction of taxes taken out = ($51 – $31) * 21 = $420
So you’ll get $420 more in your pocket throughout the year. Now look at the Federal Refund you’re expecting from your 2014 taxes…$2920! Again, assuming no major changes, that $420 can be taken from $2920 and you can still expect about $2500 next February. Not too scary, right? You still would enjoy seeing a $2500 check, I’m sure. You aren’t going to have a risk of owing when taxes roll around. But what you CAN do now is set up that Money Market Account and set up an automatic transfer of that extra $20, twice a month. And $2500 is still a pretty big FREE LOAN to the government, I’d encourage you to add another withholding or two.
Would you write a $200 check every time you go to the grocery store, even if you only spent $125? Well, the grocery store will give you back that money sometime next year, if you can prove how much of your money that they have. I’m guessing you wouldn’t be too excited about that.
Another reason to reduce your refund – we spend our hard earned money differently than “extra” money. If it goes from your paycheck to your bank account, you’re going to think hard about how you save or spend it. If it has this illusion of a “bonus” once a year, you might tend to be more careless or frivolous with it. If you have to watch your savings account get slashed when you buy that new Apple widget that you don’t need, you might choose to hang on to your money.
One of the common excuses to getting a large tax refund is that “It forces me to save…if I get that extra $50/month in my pocket, it will find a way to leak out. This way, I can count on the money being there once a year and I can intentionally use it towards [insert commendable goal here, such as paying down debt or kids’ college fund].” I empathize with what you’re saying. Day-to-day discipline is hard. And that $50/month extra in your banking account is almost invisible, so from a psychological standpoint, it doesn’t feel like you’re gaining much ground, unlike that lump sum annual deposit that makes you feel good. But apply this to a different area in your life. Instead of working out for 40 minutes, 3 days a week, you instead workout for 8 hours on a Saturday, once a month. Instead of doing something intentional for your spouse once a day, just be selfish, but plan a great getaway every couple of months where you write them a poem, take them to their favorite restaurant, do their favorite activities. Have seconds and dessert for every meal during the week but don’t eat anything on the weekend. Not only are these “plans” unhealthy, but they do nothing to develop your character or your discipline.
I encourage you to take this small step with your money this year. And really, it’s not that challenging from a discipline standpoint, if you resolve yourself with a little intentionality up front with 3 steps:
- Reduce your tax withholding
- Look at your first check to see how much of a raise you got
- Set up a recurring transfer to move that money to a “safe” place
I hope that was useful and that you can enjoy some of the benefits of understanding and having more control over your tax situation and your money.
Please, let me know if you have questions, want clarification, or have a situation that I might be able to help you with.