As tax day shall be coming around again here in the U.S., I've been thinking about personal finance a lot. Withholding for taxes is something I'm particularly thinking of and I believe I have hit upon the magic way to discuss it for people who are confused by taxes and the terminology.
What is withholding? Withholding is how much money you have taken out of your paychecks in order to prepay your taxes. The theory behind withholding is that you earn your money and a special account you have absolutely no access to is established to save money for your yearly tax bills. Yes, that's bills plural because you have Federal and State taxes and as such, you can (and probably should) establish withholding standards for each.
Withholding is based on a formula that the governments use to calculate how much money should be taken out of your paycheck so you pay your fair share based on the number of dependents you claim on your annual tax returns. In figuring out your withholding, your exemptions (usually the number of people in your household, including dependents and you who will be claimed on the same tax return) are used to calculate what specific percentage should be used to save for your taxes. Workers may withhold the maximum percentage (claiming no one is exempt) through a "0" exemption and the most the government calculations claim should be necessary will be taken out.
It's a good theory and most of the times it works. In my experience, living in New York State, having claimed "0" exemptions my entire adult life, I have never had to pay a tax bill and I have always received some money back from the Federal government. However, in New York State, tax rates change and sometimes the government calculations are off. After one year when I actually had to pay state taxes because not enough was withheld, I had to adjust my State withholding to have an additional (set dollar amount) taken out of each paycheck.
Why withhold? I withhold for two reasons. First, it is very hard for me to save. If money comes in, I spend it. Withholding at a high rate allows me to keep my finances with a level of security that is the income tax equivalent of "out of sight, out of mind." In other words, because I do not receive the money in, I don't count on it. I also never end up with a big tax bill at the end of the year, which is a distinct advantage for me.
In fact, every year as an adult that I have worked with legitimate paying jobs, withholding at a high rate, I have ended up with a big, fat, refund check (on the order of thousands of dollars). You know how I mentioned I have trouble saving? Well, through withholding, I get the magic of saving untouchable money without the temptation of it. And two out of the last four years when I did work legitimate jobs, I was able to afford lavish trips to New York City as a result of my refund checks. As a result, withholding at a high rate and even higher than the government formulas can be a way to save for big expenses without feeling like one is doing that.
Who might this not work as well for? Bigger families with more mouths to feed might find this a very problematic way to save. Indeed, it's tough to go with the "out of sight, out of mind" saving through withholding method when you have five kids who all need new shoes before the next school week. For you, cash on hand to spend might be a good idea, but you're likely to have to be realistic about family trips, then, too (you probably aren't going on them). Also, for government financial aid the gross income is often looked at, not the income after withholding. As a result, social services could be denied to working poor families who over-withhold and leave those people to starve.
But, basically, if you don't like the prospect of a big tax bill you have to come up with the money to pay (if you have trouble saving for things you want, it's pretty tough to save up to pay a tax bill you probably don't want!) claim "0" exemptions and have $5, $10, or $25 additional dollars taken out each paycheck and enjoy a yearly bonus for you and your spouse!
© 2011, 2010 W.L. Swarts. May not be reprinted without permission.