Don't Treat the I.R.S. Like a Savings Account

Picture this

scenario: Suppose you are a habitual spendthrift and have great difficulty putting money aside for savings, so you ask a trusted friend to hold money for you. Each month for a year, you give this friend $200 a month, which you cannot b

orrow against or ask to be returned to you until the end of

a full year. Your friend holds on to this money and returns it to you 12 months later – a grand total of $2,400. Now keep in mind, your trustworthy friend has gladly “held” your money for you and returned all that you gave him at the end of the year. But chances are, he may have borrowed against several times during the year. Your friend may have come up short one month and spent the $200 you just gave him. This may have happened month after month, without paying for the privilege of borrowing from you. The important thing is, your friend was trustworthy enough to make certain every penny you gave was paid back to you at the end of the year, right?

Many workers, taxpayers and savers treat the Internal Revenue Service as this trustworthy “friend.” They over-withhold taxes from their earning in order to receive a generous refund the following year. This is the only systematic way that some workers save. After all, the money is out of sight, out of mind. Surveys show that many will take their generous refund and pay down debt or put money into savings. Only a few spend it on something lavish. But is this the best way to save? Of course not.

While it seems disciplined, it robs the taxpayer of a better return. Over withholding means that the federal government gets an interest-free loan from YOU:

  • Contributing $200 a month in overwithholding for 12 months yields a tax refund of $2,400. (The government thanks you for this, by the way).
  • But contributing $200 a month to an individual retirement account for 12 months yields:
    • $2,458 at a 5 percent rate of return (compounded monthly).
    • $2,519 at a 10 percent rate of return (compounded monthly).
  • Additionally, if the contributions are going into a tax-deferred retirement account, you could save up to $600 in tax payments.

A little self-control goes a long way with a retirement account, or you can continue to bank at the I.R.S. The choice is yours.

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Comments (2)

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  1. Joe Barnett says:

    You make a very good point about the tax savings from putting $200 a month in a tax-free account rather than over-withholding in order to get a lump sum payment. I wonder if some people over-withold because they’re afraid of under-witholding and thereby incurring a penalty (you have to withold at least 90% or so of your estimated tax liability). Perhaps saving could be incentived by “holding harmless” taxpayers for underwitholding up to an amount equal to deposits to a tax-preferred account.

  2. Danilo says:

    Typically your ability to pay off stndeut loans as a college stndeut will be minimal (sorry), but I think its a mature thought nonetheless. Maybe $100 here/there can help ? Generally they are interest free until you graduate, so no worries about it compiling while your trying to finish. I’ve even heard of some folks putting their stndeut loans assuming they get a large $40K sum at once into the market and let it accrue some interest for future semesters. However, with market volatility this is a risky move, even if you were to put it in safe investments such as bonds.Once you graduate there may be legislation in place to forgive stndeut loans in the event you go into certain fields (i.e. work for a non-profit for a number of years, work in an underprivledged area of the country, etc.) But most of those proposed laws are yet to be finalized. Really, and I’m sorry for not being able to provide a more creative answer but it is what it is, you need to make good money, live within your means, and make sure the duration of the loan doesn’t exceed 10 years. Education usually, at least historically, will pay you back but its designed to be a long term investment. A 5 year plan would be considered admiral but aggressive. Assuming you make no home purchases, live with roomates, no new cars, etc. you could possibly achieve this. Life will happen and new expenses come up you haven’t even thought about just be responsible and things should work out.