Devil's Advocate 

Don’t Optimize Payroll Deductions

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This is a Devil's Advocate post.

Conventional wisdom tells us that we shouldn’t give the US Government an interest free loan by mishandling our payroll deductions. One should tweak their payroll deductions so that when they do file their taxes, the tax refund is as close to $0 as possible (or you have a little bit of a tax liability, but not too much). Honestly, there’s no financial argument against this advice because it’s absolutely correct. However, this, like many things in life, isn’t just about dollars and sometimes one has to consider psychology and human behavior. In this Devil’s Advocate post, I’ll explain why you shouldn’t optimize your payroll deductions.

It’s Not That Much Money
If you’re given a rebate of $10,000 in April, then perhaps you should check your W4 because you likely messed something up. However, for the rest of us, you probably get a maximum of a few thousand dollars in your tax refund each year. Now, if you were to keep that $5,000 (let’s put it on the high end) in a 5% interest rate bank account for a full year (again, we’re talking only the ceiling here because you pay tax each month, so you wouldn’t actually get a full year of interest) then you would end up with $250 in interest. Of that $250, assuming you’re in the 25% tax bracket, amounts to $187.50, which is an unrealistic ceiling to how much you’d save by fudging with your exemptions. While having $187.50 is better than not having $187.50, consider the reasons that follow. (Thanks Kurt for reminding me about this important reason)

You Could Mess It Up!
Now, considering how little you do earn by not giving out that free loan, you still have the problem of potentially messing it up. First off, you’re technically not allowed to claim more exemptions than you’re due in attempt to prevent this sort of optimization behavior. How will the IRS know if you’re claiming more than allowed? They won’t, unless you owe a lot of tax next April, then they’ll just tack on a whole bunch of interest charges and fines that will make the amount you earned in the bank look infinitesimal by comparison.

Also, remember that you likely aren’t paying tax on your non-job related income and so if you were to forget to include those in your exemption calculations, you could really get socked good come April. Most banks don’t withhold a portion of your interest earnings (I was surprised when Emigrant Direct did) and no brokerage will withhold any stock gains you manage to secure. So, if you had a bountiful year in the stock market, it might be nice to have that withholding “padding” there.

Government Saves It So You Can’t Spend it
The biggest psychological reason why you just shouldn’t fudge with it is because most people (this is proven by every article on credit card debt and the savings rate of Americans, which is negative at the moment) can’t save and so they really do need the government to save it for them. Certainly you can earn more by reducing your withholding and putting it in the bank, but the problem for most folks is that they won’t put it in the bank. They’ll spend it and then it’ll be gone, earning nothing in the bank.

Keeps Your Income Down So You Live Leaner
There’s something known as the wealth effect, where you feel richer when you see more money on paper. It happens most often when people see huge unrealized stock gains (or when people see unrealized real estate gains) but it also happens when people see their paychecks. If you don’t withhold as much, that take home number is larger than if you withheld more (duh), so you’re more likely to spend more because you have more. This goes into the second reason, save it so you can’t spend it, but this is where the psychology aspect comes. By keeping your income somewhat artificially low, you live with a leaner mentality and thus naturally spend less money.

I hope you enjoyed this second Devil’s Advocate post, it was a little harder to write than the one about renting forever, but I managed to think up some valid points against this generally good advice. If you have any thoughts either way, please voice them! Your opinions have been the best part about these posts.

{ 19 comments, please add your thoughts now! }

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19 Responses to “Don’t Optimize Payroll Deductions”

  1. Kurt says:

    You are forgetting one: it ain’t that much money! Multiply your refund by 2% and that’s roughly what you would have saved by accurately deducting. (Approximately 5% pretax, for half a year, reduced by 25% income taxes). It frankly isn’t such a big deal.

  2. jim says:

    Wow, how did I forget that one… I’ll add it right now. 🙂

  3. Sarah says:

    I agree with this post. I underpaid my taxes this year and am regretting it. I have the money to pay them because I do save, but I figured out the interest I earned on the money and it is about $25. That figure is so not worth the mental pain of paying money back to the government. I promtly marched up to HR to change my W-4.

  4. Rob Carlson says:

    It’s amusing how the “devil’s advocate” position distills down to “don’t game the system.”

  5. ChrisCPA says:

    That is why you are here, Jim, to show us all how to keep that extra money we get on our paychecks by spending wisely, right?

  6. jim says:

    Just showing the other side… that’s all.

  7. Debt Hater says:

    I ratcheted up my W4 withholdings when I started my new job specifically because of the advice that getting a big refund in April is just you getting back some of the free loan you gave Uncle Sam.
    Now reading this, I’m a little nervous!
    I know I didn’t save whatever I withheld from the government, I used it to pay down debt (or sometimes not) and now I’m not so sure it was a good idea. Oh well, I’ll find out and change my W4 if necessary. Thanks for the post!

  8. CPA1298 says:

    I love the Devil’s Advocate series; keep it up. I’ve made the arguments before about renting and cranking up withholding, and nearly got punched by my friends and co-workers. People get simple ideas pounded into their heads and won’t listen to new ideas. The withholdings argument made even more sense a couple years ago, when CDs were returning 2%.

    How about this for a topic – “Don’t invest in your 401(k) plan”

    1) The match is overrated – many people don’t stay at their jobs long enough to vest.
    2) The money is tied up, and unavailable for important stuff like paying down unforeseen consumer debt, etc.
    3) Most 401(k) plans’ fund choices are not optimal
    4) (worst of all) You’re converting gains that would be long-term capital gains into ordinary income. And, when you die, there is no step-up in basis; your kids will pay ordinary income rates instead of inheriting the stocks at their fair market value on the date of death (as would be the case in a taxable account).

    Anyway, you have a great blog and great post.

  9. Tricia says:

    Jim – Yes! Yes! I second the “Don’t invest in your 401(k)” idea 🙂

  10. jim says:

    The 401k one is on tap, don’t you worry… 🙂

  11. Kurt says:

    I would add to the analysis some kind of consideration about timing: since you withhold throughout the year, you shoud calculate the lost interest on an average balance, not year end. Other than that, thanks for reading the comments! Keep up the great worth (especially wrt this series: more wisdom here than many of your fellow bloggers might recognize).

  12. Foobarista says:

    I disagree, particularly in our case. If you’re self-employed, paying quarterly payments is a royal pain. We tweak my salary withholding to hit the safe-harbor rules in the first quarter and set aside 33% of my wife’s SE income in a special savings account that we use to pay taxes due. Anything left in the savings account is our “refund” – once we’ve paid taxes, we use the rest to round out previous year’s retirement account funding (Roth, SE401K, etc).

  13. BeefStooge says:

    Funny….I posted something on upping my W-4 about 2 minutes before I read this. I think your points are though provoking and have some validity, but…

    While it is true isn’t that much money, I’d counter that by saying that to me it’s the principle more than the amount. In other words, I don’t like the fact that they have the money and I don’t, whether it’s $25 or $25,000.

    As far as your other points go, I feel that successful personal finance boils down to information, behavior, and discipline more than anything else. I won’t “mess it up” so long as I’m informed, it will not help me to “live leaner” because I am already disciplined, and they don’t need to “save it for me” because my behavior dictates that I’m a saver to begin with.

    Keep it up! It’s always great to hear the other side of anything!!!

  14. mbhunter says:

    You can use excess withholding to offset the need to pay quarterly self-employment tax, too. It gives you a cushion if you find out that you have to file Schedule SE of form 1040.

  15. moominoid says:

    I don’t fine tune my with-holding for all the reasons mentioned here. In fact I apparently have my with-holding set at zero exemptions. This year I expect that even so I might end up paying additional tax in April for the first time. Is there a way of with-holding even more tax? Or do I need to go to estimated tax payments?

  16. jimbo says:

    DA to the DA…

    Perhaps the interest earned on a regular bank savings account is not worth the risk of over estimating withholding allowances. And it maybe it’s not a big deal to loan Uncle Sam the money free of charge for a year or so.


    Given the abysmal deflation of the dollar recently, even if I get back all my excess witholding in refunds, I loose purchasing power both to inflation and currency deflation. Ironically, It’s Uncle Sam who makes those same dollars worth less at the end of the year with his free-spending government fiscal policies. What’s the present value of those dollars received a year from now, factoring in both inflation *and* currency devaluation caused by Fed policies designed to benefit and protect Uncle Sam and his spiraling debt?

    The sooner I can get those dollars and invest them in hard assets with a chance of appreciation, the better. Heck, if my assets just hold value I’m ahead of the game. If Uncle Sam holds my dollars, he gives me back dollars that are worth less than when he took them.

    So, my real gain is my not only return I earn on my investments, but also preservation of spending power. If I can invest these dollars for long-term capital gains, I pay less tax than cited in the example. Futhermore, if I utilize some of the fantastic personal retirement investment vechicles (Roth IRA’s, solo K’s, etc), then I can potentially invest these dollars at *zero* taxable gains!

    Consequently, If I get all my excess withholding dollars back via a tax refund, I suffer loss. I hate loosing money! Even if it’s a few hundred dollars gained by getting those dollars now rather than later, It’s worth it to me. Maybe it’s just the principle of the whole thing.

    Just the other side chiming in….


  17. Chris says:

    I’m one that agrees with Jimbo’s thoughts on this.

    If I have that money now (instead of April), I’ll have that to better invest now.
    Because of our earlier frugality (great credit, and high credit amounts available to use), we can use someone else’s money to purchase investment properties and fix them up. Then resell them for a profit. The current one we’ve put an offer on can yield us between $5,000 & $20,000, depending upon what a buyer will pay for it. Keep in mind we aren’t using any of our own money, just borrowing on 0% cards and such to use someone else’s money for a small price of $75 or so (to borrow $30,000 in one case).
    Let’s see, spend none of our own money (yes, I include the balance transfer fees in my calculations), and get between $5,000 – $20,000 in a 6 month timeframe. Admittedly these situations don’t occur often.

  18. Sylvie66 says:

    I totally agree with BeefStooge – it’s the principle of the matter. The US taxes overwhelmingly go to pay for programs that …. well, let’s just say that I would reallocate the funds if it were my business!
    The key phrase in the devil’s advocate piece is “human behavior”. For those of us who are frugal and informed, saving for our tax bill is just another business expense.

  19. Hank says:

    I personally like having something similar to a Christmas Bonus but in February when I get my income tax refund back after filing. It is really nice to have extra money that you weren’t orginially expecting even though it is my own money to start with.

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