How many times have we complained about paying too much in income taxes, both federal and state? And yet, other than violating the tax laws, what choice do we have? The answer is plenty. By simply rearranging how we deploy our money, we can reduce our tax bill, save more for retirement, and have the federal and state governments subsidize our out-of-pocket health care costs. Let’s consider how.
First, experience tells me that most employees get income tax refunds, both federal and state. However, my accountant friends remind me that they would be fired if any of their clients receive tax refunds. Why? Because, if you receive a tax refund, you have effectively given the government an interest-free loan of your money. The government keeps the interest it earns on the money that’s “overwithheld” from your paycheck. By having too much withheld from your paycheck, you are shortchanging your financial future.
As an example, let’s say an employee gets a federal tax refund of $1,040. Again, by giving the government an “interest-free loan,” this employee is hurting his financial future. Let’s see how. If the employee divides the amount of his refund by the number of his pay periods ($1,040 divided by 52), the result is $20. The $20 is the amount this employee is “overpaying” his taxes each pay period. If the employee instead immediately redirects the $20 to the company 401k savings plan, he will instantly owe less federal and state income tax. This happens because 401k contributions reduce your taxable income by the amount of the contribution (up to a limit of $18,000 annually in 2017; $24,000 if you’re 50 or older). But it gets even better. If his current 401k contribution is less than 5% of his eligible compensation, he would receive an additional company matching contribution for his 401k.
By the way, as an added benefit, his paycheck would not go down by $20 if he followed this strategy. Why? Because by redirecting the $20 to his 401k, he will have also reduced his overall tax liability because he will be taxed as if he earned $20 less per paycheck. Therefore, with less federal and state income taxes due, his take-home pay will only fall by approximately $15 in this example.
If you received an income tax refund last year and your tax situation didn’t change this year, see if the same income tax-saving magic described here can work for you. All you have to do is call payroll and ask someone to adjust your withholding amount and follow the same steps the employee did in the example depicted here. Good luck in saving taxes and improving your future financial situation.
Dr. Carboni holds a doctorate degree in the social aspects of retirement (social gerontology) from the University of Connecticut. He headed a university-based Center on Retirement for 7.5 years and was editor of Retirement Planning, the official journal of the International Society for Retirement Planning. He holds a Certified Financial Planning (CFP) designation from the College of Financial Planning in Denver, Colorado. His workshops combine a balanced blend of lifestyle planning and financial strategies to help participants create a satisfying lifestyle with sufficient resources to sustain their retirements. He has taught at a variety of large corporations and provides seminars at Ulbrich.