Is It Wise to Pay More Taxes Periodically to Get a Refund?
The debate around paying more in taxes each month to receive a refund is a complex one. There are valid arguments on both sides, and it ultimately depends on individual financial situations and priorities. In this article, we will explore the pros and cons, along with practical advice on optimizing your tax withholdings and saving for your future.
The Pros and Cons of Paying More Taxes Monthly
One common argument against paying more in taxes each month is that it amounts to a no-interest loan to the government. The government doesn't offer any extra benefits for overpaying, and you could earn more money by investing or saving with a better return than what the government offers.
On the other hand, some argue that paying more taxes each month can be beneficial if you expect a large, irregular income later in the year. Additionally, there are instances where people have unearned investment income and want to balance their tax payments accordingly to avoid large tax bills.
Why the IRS Advise Against Overpaying
Both sides of the debate agree on one thing: the IRS shouldn't hold onto your money for most of the year if you don't need to. According to the IRS, you should avoid deals that promise "instant tax refunds" as they are not in your best interest. By overpaying, you essentially hand the government a no-interest loan.
The Right Way to Handle Tax Withholding
The best practice is to have the IRS withhold the correct amount from your paycheck so that you neither owe a large sum at the end of the year nor get a substantial refund. This can be managed through your W-4 form, which allows you to adjust your number of allowances and thus control how much tax is withheld from each paycheck.
For those who are new to managing their withholdings, it can take some experimentation to get the right balance. The goal is to keep the balance due or refund as close to zero as possible. Doing this ensures that you are neither depleted of unnecessary funds nor left with an unwelcome surprise in the form of an unexpected tax bill.
Maximizing Your Savings: The Benefits of a 401k Plan
A more effective savings strategy involves setting up a 401k plan through your employer. Contributions to a 401k plan offer a dual benefit: you can save money for your future and potentially receive a matching contribution from your employer. This is essentially 'free money' that can grow tax-deferred over time.
Let's consider an example. If you earn $100 a week, your taxes are automatically deducted, and you take home around $80 per week. However, if you contribute 10% to your 401k, your take-home pay would ostensibly reduce to $80. But here’s the key advantage: you're not actually reducing your earnings by $10. Instead, you're investing $10 in a savings account where it can grow. At the end of the year, your effective earnings are $90.
Furthermore, if your employer matches your contributions, you're effectively putting $20 away each week, which grows over time with compounding interest. This is a win-win situation, as you are getting more money in your future and achieving tax savings now.
Conclusion
Whether you decide to pay more in taxes each month or not depends on your financial goals and circumstances. Overpaying is generally not recommended as it amounts to a no-interest loan to the government. Instead, using a 401k to save for the future and leveraging employer matches can be a more beneficial strategy. By optimizing your tax withholdings and saving effectively, you can ensure financial security and achieve your long-term goals.