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Health & Fitness

Are Excess Tax Withholdings a Source of New Savings?

Most of us don’t think much about the amount of federal income tax withheld from our paychecks until it’s time to file our annual tax returns. Some may even view the result on their tax returns as a great mystery – will they owe money to the government by April 15 or will they get a refund back? According to statistics released by the Internal Revenue Service (IRS), close to three in four Americans received a federal income tax refund in 2013 (for 2012 tax returns).* That means some people may be withholding too much from their paychecks – money that is, in essence, being lent to the government, in some cases for a year or longer before it’s reclaimed as a tax refund. 

In the ideal scenario, the amount of federal income tax withheld from each paycheck would be as close to matching a taxpayer’s total income tax liability for the year as possible. But, estimating the total income tax liability for the year in advance may be a challenge. After all, income levels, total deductions a person can claim on their tax return or tax laws themselves can vary from year to year. All of these factors affect how much income tax a person owes in a given year. 

These complexities aside, there are steps you can take to more accurately estimate the proper amount of federal (or state) withholding from your paycheck. It doesn’t take much to adjust your withholding, and it can work to your benefit. 

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Refunds can be significant

According to the IRS, the average refund paid out in 2013 (for 2012 tax returns) was $2,744*. That amounts to more than $100 in excess-withholding per paycheck for taxpayers who are paid by their employers every two weeks. It may be a relief for some people to receive a refund rather than being required to make a payment to the IRS when filing their income tax returns. However, many people aim to minimize the amount of the refund by estimating their tax liability and adjusting their withholding to match this amount as closely as possible. 

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Some people find that if they adjust the withholding amount on a paycheck based on their estimated tax liability to reduce excess-withholding, they may be able to direct the money from their paychecks (no longer dedicated as withholding) to a workplace retirement plan such as a 401(k) or 403(b) plan or an IRA. Investing in a workplace retirement plan may make it easier to systematically save for retirement. For example, let’s say someone reduced their federal income tax withholding by $100 each paycheck over 26 pay periods in a year and put it in a retirement plan. After 20 years, they’d have invested $52,000 toward retirement. (It’s important to note that the account balance could be more or less than this at retirement because of investment returns and taxes.) 

It’s not to say that you can’t use this same retirement investment strategy with your tax refund money. However, it’s a common temptation to think of a tax refund as “found money” that can be spent on fun extras rather than directed toward long-range goals. Many find it easier and more effective to systematically save over the course of the year. As an added benefit, you may be able to lock in interest or other growth by investing it over time. 

It starts with simple paperwork

Life circumstances may have changed – marriage or divorce, the purchase of a home, the addition or departure of dependent children in your family – since you last completed form W-4, Employee’s Withholding Allowance Certificate. All of these factors may have changed your tax status and the withholding amount you should be claiming. Now is a good time to determine if you can structure the income tax withholding on your paycheck in a more efficient way. If you see an opportunity to adjust your income tax withholding amount, consult a tax advisor or talk to your employer about filling out a revised W-4 form.                     

*IRS News Release, Dec. 4, 2013

 

Rob Davis lives in University Place with his wife Lorri and sons Wesley and Parker. He is a Financial Advisor and CERTIFIED FINANCIAL PLANNER practitioner™ with Ameriprise Financial Services, Inc. in Tacoma, Washington. Rob specializes in fee-based financial planning and asset management strategies and has been in practice for 36 years. He is licensed/registered to do business with U.S. residents only in the states of Washington, Idaho, Arizona and California. You may contact Rob at ameripriseadvisors.com/robert.g.davis.

Ameriprise Financial Services, Inc. Member FINRA and SIPC. 

Ameriprise Financial does not provide tax or legal advice. Consult your tax advisor or attorney. 

© 2014 Ameriprise Financial, Inc. All rights reserved.
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