Ask the Experts: Should I adjust my federal income tax withholding?

Ask the Experts: Should I adjust my federal income tax withholding?

Did you owe taxes on your 2005 federal income tax return? If so, you may need to increase the amount of federal income tax that’s withheld from your paycheck by completing and filing a new Form W-4 with your employer. (If you’re self-employed, you’ll have to bump up your quarterly estimated tax payments.) Not having enough withheld can result in more than a cash crunch at tax time—it can mean penalties and interest.

On the other hand, receiving a large federal income tax refund can be an indication that you should adjust your withholding as well. Why? A large refund essentially means that you’ve provided Uncle Sam with an interest-free loan over the year. Think of it this way: If you receive a $4,000 refund, in 2005 you paid approximately $333 more each month to the federal government than you had to. Sure, you get that money back in the form of a refund when you file your tax return, but the government doesn’t pay you any interest on those funds.

If you had taken that $333 every month and instead invested it in an account that earned 5.5% annually, you’d have over $4,150 by the time your tax return was due. That’s an extra $150. And, depending upon how you invested the funds, you’d be able to access those dollars during the year if you had the need.

If overpaying the government during the year is the only way that you can force yourself to save, go right ahead. Just recognize that there’s a lost opportunity cost in overwithholding. Consider investing those dollars instead; or better yet, talk to your employer about contributing those dollars to a 401(k) plan or an IRA through payroll deduction. Like withholding, these contributions will come directly out of your pay; unlike withholding, though, those funds will be working for you instead of for Uncle Sam.