Most of us pay taxes as part of our paycheck each month, as Uncle Sam mandates it to be. For many people, this means overpaying a little bit each month “just to be safe”, and getting a nice fat tax refund the following year (We ourselves got $1,046 back this year). But, as others have pointed out, this is the equivalent of giving the government a interest-free loan. I don’t know about you, but I’d much rather take an interest-free loan myself. So instead, why not withhold as little as possible, invest the money you would have paid out somewhere earning interest instead, and in April pay back the government what it’s due. (Similar to taking advantage of 0% APR credit card offers.) But how little can you pay?
First, you’d want to figure out how much tax you are supposed to pay this year. For this, the IRS has kindly offered us the IRS Withholding Calculator. Having your pay stubs and previous tax return handy will help you punch in the numbers. The calculator will estimate how much tax you should pay for 2005, and based on what you’ve already paid, tell you how many allowances to claim on your W-4 form and any additional amounts to withhold from your paycheck(s) each month. We are a dual-income no-kids family, so our tax bill is a bit heftier, and the calculator recommended 0 allowances and also $147 per paycheck.
Second, how little can you pay without having to pay a penalty at the end of the year? For this, I reference Topic 306 – Penalty for Underpayment of Estimated Tax at IRS.gov. I quote:
“Most taxpayers will have paid enough tax to avoid this penalty if they have paid at least 90% of the tax shown on the return for the current year, or 100% of the tax shown on the return for the prior year, whichever is smaller. However, if your adjusted gross income was greater than $150,000 in 2003, or $75,000 if you are married filing a separate return, the test is 90% of the tax shown on your 2004 tax return, or 110% of your 2003 tax, whichever is smaller. There are also special rules for farmers and fishermen.”
We make less than $150k, and the only thing I can grow is weeds, so for us personally it boils down to:
1. 90% of the tax to be shown on your 2005 tax return, or
2. 100% of the tax shown on your 2004 tax return
Based on the calculator, our estimated 2005 tax bill is $10,986. 90% of that is $9,900. We paid only $8,600 in taxes this year, as my wife only worked part of the year. So it looks like we’ll only have to pay $8,600 in taxes this year to avoid a penalty. I’m going to set 0 allowances for both of us and $20 per paycheck to bring it close, and review it in October to make sure.
Finally, is this worth the bother? Last year, I overpaid by $1,050. It looks like I am allowed to underpay this year by $1,300. If I divide this $2,350 difference into 12 monthly parts of $196, and invest it every month at 3% interest (est.) for a year will get me… $41. Not too exciting, but hey, it’s something. And it only takes a quick note to your HR dept to change your withholding amount.
(In addition, if you have any credit card debt or other loans with high interest rates, your payoff will be greater.)
If you’d like, go ahead and run the numbers for yourself. I know people who got $5,000 back this year, so in that case your savings would be in the hundreds of dollars and worth a look.