You fill in a W-4 each time you start a new job. Using your W-4, your employer calculates the amount of withholding to apply to your paycheck each month. If you withhold too much, the IRS refunds you the excess at tax season each year. If you withhold too little, you have to pay the IRS the difference. Most Americans withhold too much. That is why the average amount of refunds per taxpayer based on last year’s taxes collected is $2,847. Click here to watch or read more information on IRS Back Taxes.
Obviously you should not be paying Uncle Sam more than you are taxable. To change the amount of withholding, you need to change your W-4. Most of us forget to make the necessary changes after a significant life event that may reduce your taxable income such as the birth of a child or getting married. That is one main reason why we pay too much withholding.
So should you reduce your W-4? Naturally, you should consider changing your W-4 only if you are paying too much withholding. Reducing your W-4 means reducing the amount of refund you receive each year. Getting a lump sum refund of about $2,847 sounds good but actually, it’s the amount your should not have paid the IRS in the first place. So deciding to reduce your W-4 should depend on what you would do if you do not receive a refund.
Consider how much your monthly income would be if you did not withhold the $2,847. It would immediately increase by $237.25 per month. If you are not the type of person that can discipline yourself to spend the $237.25 wisely or better still, save the entire amount each month, then it’s better if you do not change your W-4. It’s better to let the government take a little more every month and refund it back to you at the end of a year than you spend it all on unnecessary things. After all, if you can get by with the withholding at your present amount, it means you do not need the extra $237.25 anyway.
Then when the government refunds it to you in one lump sum of $2,847, you could use it for something beneficial like paying off your credit card debts. The only thing you would lose out on is the interest on that $2,847 each year. But that may be a small price to pay for not allowing yourself to fritter away your hard earned money.
If you do decide to reduce your W-4, I’d like to suggest two things you could do with the extra $237.25 each month.
Firstly, you may want to start a 401(k) to save for your retirement. At 6.5% compound interest, your monthly savings of $237.25 per month could end up being more than $3,000 in one year’s time.
Secondly, pay off your debts. Most of us have credit card debts. Paying $237.25 per month towards your credit card is a good practice. If you have a credit card balance of $2,500, a monthly payment of $237.25 could pay off your entire balance within one year.
So be wise in deciding whether you should make changes to your W-9.