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Don’t Optimize Payroll Deductions
Posted By Jim On 01/08/2007 @ 8:19 am In Devil's Advocate | 19 Comments
Conventional wisdom tells us that we shouldn’t give the US Government an interest free loan by mishandling our payroll deductions. One should tweak their payroll deductions so that when they do file their taxes, the tax refund is as close to $0 as possible (or you have a little bit of a tax liability, but not too much). Honestly, there’s no financial argument against this advice because it’s absolutely correct. However, this, like many things in life, isn’t just about dollars and sometimes one has to consider psychology and human behavior. In this Devil’s Advocate  post, I’ll explain why you shouldn’t optimize your payroll deductions.
It’s Not That Much Money
If you’re given a rebate of $10,000 in April, then perhaps you should check your W4 because you likely messed something up. However, for the rest of us, you probably get a maximum of a few thousand dollars in your tax refund each year. Now, if you were to keep that $5,000 (let’s put it on the high end) in a 5% interest rate bank account for a full year (again, we’re talking only the ceiling here because you pay tax each month, so you wouldn’t actually get a full year of interest) then you would end up with $250 in interest. Of that $250, assuming you’re in the 25% tax bracket, amounts to $187.50, which is an unrealistic ceiling to how much you’d save by fudging with your exemptions. While having $187.50 is better than not having $187.50, consider the reasons that follow. (Thanks Kurt for reminding me about this important reason)
You Could Mess It Up!
Now, considering how little you do earn by not giving out that free loan, you still have the problem of potentially messing it up. First off, you’re technically not allowed to claim more exemptions than you’re due  in attempt to prevent this sort of optimization behavior. How will the IRS know if you’re claiming more than allowed? They won’t, unless you owe a lot of tax next April, then they’ll just tack on a whole bunch of interest charges and fines that will make the amount you earned in the bank look infinitesimal by comparison.
Also, remember that you likely aren’t paying tax on your non-job related income and so if you were to forget to include those in your exemption calculations, you could really get socked good come April. Most banks don’t withhold a portion of your interest earnings (I was surprised when Emigrant Direct did) and no brokerage will withhold any stock gains you manage to secure. So, if you had a bountiful year in the stock market, it might be nice to have that withholding “padding” there.
Government Saves It So You Can’t Spend it
The biggest psychological reason why you just shouldn’t fudge with it is because most people (this is proven by every article on credit card debt and the savings rate of Americans, which is negative at the moment) can’t save and so they really do need the government to save it for them. Certainly you can earn more by reducing your withholding and putting it in the bank, but the problem for most folks is that they won’t put it in the bank. They’ll spend it and then it’ll be gone, earning nothing in the bank.
Keeps Your Income Down So You Live Leaner
There’s something known as the wealth effect, where you feel richer when you see more money on paper. It happens most often when people see huge unrealized stock gains (or when people see unrealized real estate gains ) but it also happens when people see their paychecks. If you don’t withhold as much, that take home number is larger than if you withheld more (duh), so you’re more likely to spend more because you have more. This goes into the second reason, save it so you can’t spend it, but this is where the psychology aspect comes. By keeping your income somewhat artificially low, you live with a leaner mentality and thus naturally spend less money.
I hope you enjoyed this second Devil’s Advocate post, it was a little harder to write than the one about renting forever , but I managed to think up some valid points against this generally good advice. If you have any thoughts either way, please voice them! Your opinions have been the best part about these posts.
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 Devil’s Advocate: http://www.bargaineering.com/articles/category/devils-advocate/
 not allowed to claim more exemptions than you’re due: http://www.irs.gov/govt/fslg/article/0,,id=112714,00.html#1
 unrealized real estate gains: http://www.bargaineering.com/articles/my-house-appreciated-44000.html
 renting forever: http://www.bargaineering.com/articles/rent-forever-dont-buy-a-home.html
Thank you for reading!