You’re in an “overwithholding” situation if too much tax is withheld, resulting in a refund. But the instructions on how many allowances to claim for tax credits are geared toward overwithholding, according to a report last year from the Government Accountability Office.
About three-quarters of wage-earning taxpayers have too much withheld from their paycheck, the GAO said.
For you to neither owe the government nor get a refund, your total withholding allowances have to match the tax deductions and credits reported on your federal return. With the right withholding, you can get close enough to breaking even with a small refund or tiny tax bill.
Behavioral economists look at the mental accounting people do when faced with a choice of receiving money incrementally or in one large chunk. Turns out that, psychologically, most people prefer the lump sum.
“Americans want tax refunds because getting money on April 15 feels like a bonus,” Dan Ariely and Jeff Kreisler write in their book “Dollars and Sense: How We Misthink Money and How to Spend Smarter.”
When money is received monthly in relatively smaller amounts, it can be harder to save, because there are more immediate needs.
However, let’s say you’re carrying credit-card debt. Rationally, any extra money in your paycheck could be used to reduce the debt throughout the year, so you would pay less interest.
Ironically, polls show that consumers anxiously await their tax refund just so they can pay down debt.
A Kaiser Family Foundation poll last year focused on the potential impact of the 2017 tax law on individuals. People were asked: “If you receive a tax refund as a result of this tax plan, what will you do with that tax refund? Will you save or invest it, pay off a bill or debt, or spend it on something you have put off?”
Thirty-six percent of respondents said they would save or invest the money, and 44 percent said they would pay off a bill or debt.
Here’s my concern. Overwithholding comes with a cost. If you don’t have savings throughout the year — which you might if you had less money withheld from your paycheck — and you’re faced with a financial emergency, you could end up increasing your credit card debt.
Overwithholding is not good for low-income workers who struggle with having enough cash every month. Some end up paying their bills late, negatively impacting their credit rating. Or they get trapped in a cycle of expensive payday loans to make ends meet. They “could benefit more from larger regular paychecks than from larger annual tax refunds,” the GAO concluded.
For many people, the allure of getting a tax refund is clearly so big that they easily overlook its true cost. When you overwithhold from your paycheck, you’re essentially just giving Uncle Sam an interest-free loan. And for that, you gain nothing.
