Monthly Investment Message: March 2017

Barbara O’Neill, Extension Specialist in Financial Resource Management

Rutgers Cooperative Extension

March 2017

Don’t Overwithhold Income Tax Money- Invest It

Many people deliberately have extra federal and state income taxes withheld from their paychecks. Two advantages of overwithholding are that there’s no access to this money and, therefore, it can’t be spent recklessly, and the refund makes a nice windfall once a year to pay off debts or buy “big ticket” items. Two disadvantages are that taxpayers must wait a year to collect their money and the government pays no interest.


Perhaps the biggest disadvantage, however, of overwithholding is the risk of having a tax refund delayed as a victim of tax identity theft. This happens when fraudsters use stolen personal identification information (e.g., name and Social Security number) to file a fraudulent tax return claiming a fraudulent refund. Victims can wait months for their money as they take steps to file paperwork to verify their identity with the IRS. Tax identity theft is a commonly reported type of identity theft according to the Federal Trade Commission (FTC).


Tax liability, or the amount that a person owes, is based on taxable income and tax deductions, exemptions, and credits.  A small refund, say $500 or less, may be fine, but if you’re getting back more, you’re losing foregone interest on money that could have been saved.  You also run the risk of having to wait for a large sum of money if you are an identity theft victim. Social Security numbers are often obtained illegally through database hackings that people have no control over.


The amount of the income tax withholding is based on the number of allowances that a person notes on their W-4 form that is filed with their employer. Essentially, if income taxes are overwithheld, a paycheck is smaller, and a tax refund is larger.  In simple terms, tax withholding can be explained this way:

More withholding = Smaller paycheck = Bigger tax refund

Less withholding = Larger paycheck = Smaller tax refund or taxes owed to the IRS


W-4 forms are required the first day on a job. The Employee’s Withholding Allowance Certificate section on the bottom of the W-4 form tells employers how much tax to withhold based on a formula from the IRS.  Anyone can change their W-4 form at any time with their employer and undo their overwithholding. Just be careful not to overdo it. Essentially, taxpayers must pay 90% of their current year tax liability to avoid a penalty plus interest.  However, there is a “safe harbor” exception rule: no penalties are due if a taxpayer paid at least as much (i.e., 100%) of their prior year’s tax bill (i.e., the tax due shown on their prior year’s tax return) or 110% of the prior year’s tax amount if adjusted gross income (AGI) was more than $150,000.


Employees can also request to have additional taxes withheld from a paycheck to cover taxes owed on taxable income such as capital gains, investments, and self-employment.  For example, they could put “0 allowances + $50” on their W-4 form. Another reason to have extra taxes withheld is the “marriage tax” where married couples with two employed spouses pay more tax together than they would if each spouse filed as a single taxpayer. This is especially true if each spouse has a similar income such as two spouses earning $35,000 for a total combined gross income of $70,000.


In cases where workers are self-employed, similar types of calculations are required. However, in this case, tax payments are estimated and remitted directly to the IRS rather than being withheld from a paycheck. The IRS Form 1040-ES, Estimated Tax for Individuals, contains a self-employment tax worksheet and quarterly estimated tax payments to the IRS are due in April, June, September, and January of the following calendar year. After their first year of sending in estimated payments, taxpayers generally receive a “coupon book” from the IRS and their state income tax agency.  Included are tax payment vouchers for each quarter and addressed mailing envelopes.


What does income tax withholding have to do with investing for your future? Everything! Adjusting tax overwithholding downward, closer to the actual amount that will be owed, frees up money to invest. Over time, the return on this money can be impressive. Let’s say a worker has $100 more available each month by reducing tax withholding or quarterly estimated payments. In 30 years at a 6% interest rate, this savings will grow to about $100,950.


A helpful resource is the IRS Withholding Calculator Results from the calculator can help workers complete their W-4 form to avoid having too much or too little tax withheld from their pay. Remember, the sooner your money gets invested, the longer it will earn compound interest.


Check out our Archived Monthly Investing Messages