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.