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Washington's December tax-policy deal produced a temporary tax cut for most workers — in the form of a one-year reduction in the Social Security payroll tax. Depending on your income level, all else being equal, that cut translates into a 2% increase in take-home pay this year.
But if you want even more in your paycheck, you just have to ask. Really. Well, at least up to a point.
If the government is taking too much from your pay, you can simply adjust your income-tax withholding downward. Doing so won't reduce your overall income-tax liability, of course, but tens of millions of Americans currently over-withhold, essentially giving Uncle Sam an interest-free loan with every paycheck.
Here are the statistics. In 2010, 96.3 million Americans (more than 80% of taxpayers) received an income-tax refund. The average refund was $2,887. That means, on average, those getting a refund overpaid the IRS by about $240 a month during the previous year!
To be sure, it's not always easy to figure one's withholding accurately, especially in a year in which you experience big changes that affect your tax situation (e.g., the birth of a child, a home purchase, a significant change in income). But getting a large income-tax refund year after year is often a sign of poor planning.
Instead of overpaying your income tax with every paycheck, wouldn't it be better to put that money into interest-bearing savings?
Consider Mr. and Mrs. Average Taxpayer. Last spring, they were excited to get their refund of $2,887. But if this couple, instead of over-withholding by $240 a month, had saved that money in an account earning just 1.5% interest, they would have had savings of $2,900 by the end of 2009 — and they would not have had to wait months for a refund.
Now consider what would happen if Mr. and Mrs. Taxpayer invested that $240 every month for 20 years. As you can see in the table, those savings could add up to a tidy nest egg. (Of course, interest earnings will be taxable unless the money is saved in a tax-advantaged account such as an IRA.) The bottom line: if you set your tax withholding too high, you're giving up — or at least unnecessarily delaying — a great opportunity to build your savings.
The ideal withholding amount would leave you owing no additional tax and receiving no refund. But since many things can affect your tax situation over the course of the year, this ideal is difficult to achieve. A more realistic goal is to finish each year owing a small amount or receiving a small refund. (It's good to be a tad conservative so you don't under-withhold by too much and end up facing an IRS penalty. Usually, you can avoid a penalty if your withholding equals at least 90% of your tax liability.)
If you've been using over-withholding as a "forced" way to save, set up an auto-deposit system with your bank or employer instead. Such a system will send your money directly into a savings account rather than to the IRS (this is a great way to fund an Individual Retirement Account too).