It’s that time of year. It’s tax time. April 15th is right around the corner and for many people it isn’t exactly a happy day. It’s not happy because many people find out they need to write large checks to pay taxes. Here’s a tip that will help make the dreaded day a little rosier. Make sure you withhold the proper amount on your W-4. Given today’s interest rate environment it doesn’t make sense to claim a lot of exemptions. It would if interest rates were higher but they are not right now so keep your exemptions low.
The last article I wrote featured my daughter and her first investment account. This one goes back to the beginning of her first job, her first day. On her first day, her employer put a form in front of her called a W-4. They asked her to fill it out and her response determines how much of her salary, what is called gross salary, would go to her every pay period and how much would be set aside to pay taxes on April 15th. If she claimed few exemptions, more would be taken out of every paycheck so that effectively she would have less to spend every pay period. Her net salary would be lower. If she claimed high exemptions less is taken out every pay period, she would have more to spend every pay period. Her net salary would be higher. She called me up and asked me what she should do. Here is what I told her.
I explained that she should review her W-4 situation once a year and make adjustments accordingly. I explained that federal taxes are due for everyone in the country on April 15th and that the question her employer was asking through the W-4 form wasn’t do you want to pay more or less taxes, but do you want to prepay your taxes so that you don’t owe anything on April 15th and you might even get a refund. I then explained that the analysis of what she should do isn’t a black and white analysis. I explained that the W-4 provides financial flexibility. It lets you determine if you wanted to prepay your taxes, essentially giving the taxing authority and interest free loan until you file your taxes, or if you wanted to have that money for yourself and pay what you owe on April 15th. I suggested that she have very few exemptions and now that tax time is approaching she will see the benefits. I call this exemption redemption.
Why did I tell her to claim few exemptions? Why did I recommend she take a lower net salary? The answer is twofold. 1) In this interest rate environment with rates being very low, the cost of loaning money to the taxing authority isn’t very much. She is not giving up a lot of potential interest or what economists call opportunity cost. 2) In my experience, when people opt for the higher net salary by taking high exemptions they are succumbing to what I call the optimism bias. They believe they will take the extra money from every paycheck and save it and invest it wisely until tax time rolls around. It’s one of the things I admire about people. They are optimists. Unfortunately, while this is a great plan and it looks good on paper and in theory, it stinks in practice. Most people spend the money and have to scramble to pay taxes on April 15th. It’s ok to be an optimist. However, optimism without execution doesn’t work. Until such time as interest rates are higher, lower exemptions seem more appropriate.
