Planning for Income Taxes, Part 1: Exemptions

Tax Planning: Should you try to receive a larger lump sum via your tax refund or claim more exemptions and increase your take home pay year-around?


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Until today, I would have strongly recommended the latter, afterall why give the government a tax free loan? However, a few days ago I was filing my fiances taxes and found that her refund was relatively small. She didn’t owe anything, but wasn’t getting a chunk of cash back that she was accustomed to receiving. From an accounting perspective, I tried to explain why this was but she truthfully hates numbers and didn’t want to hear it so I let it go. It struck me as interesting however because I couldn’t think of anything more useless than paying excess income taxes throughout the year in order to get a refund that doesn’t pay interest. However, it all depends on how the money would be used during the year and what it is used for when the lump sum refund comes.

Sad as it may be, when the average person gets an increase in income, their spending increases to use the additional income. Let’s say you normally get a refund of $5,200 each year; were you to receive that on bi-weekly paychecks instead, you would take home an additional $200 per paycheck. Wouldn’t that be wonderful? But what would you do with it? Statistics say that most of us would spend more money in our day-to-day lives and have nothing to show for the additional income. Does that really benefit your financial well-being? Probably not…

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What if you got the $5,200 refund in February or March? Perhaps it allows you to take a vacation during the summer without using credit cards, take care of costly home or automotive repairs you couldn’t afford otherwise, or payoff credit card debt lingering from Christmas. So for most of us, it seems much more advantageous to allow the government an interest-free loan by taking higher tax withholding than by receiving a smaller increase on each check.

I can think of two exceptions to this conclusion:

  • If you’re underwater already, meaning you’re going into debt each month because the ends do not meet, the additional income on the paycheck-to-paycheck basis would be more useful because it would mitigate the accumulation of debt.
  • If you are disciplined enough to use the additional income to save on your own throughout the year, you would not only accumulate the lump sum but would also be paid interest on your savings providing even more income.

The problem is most of us are not disciplined and would allow the additional money to get wrapped up in our day-to-day spending eliminating any substantial financial benefit from your income. I have heard that some individuals will ramp up their exemptions on their W-4 in order to have fewer taxes withheld. Take caution in such an endeavor as the IRS discourages such practices and federal law mandates that you pay quarterly income taxes if the amount being withheld is insufficient.

Surprisingly, this very brief domestic discussion changed my perspective on withholding tax completely. It is more beneficial to most taxpayers to allow standard withholding and receive a large refund at year’s end.

For a more detailed look at personal exemptions, visit the Internal Revenue Service’s page on Publication 501. (Personal Income Taxes)

Have something to add? Please comment here or email me.

Internal Revenue Service
CNN Money
Wall Street Journal: Personal Finance

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