If you are a standard employee (not an independent contractor, self-employed, etc.), one of the items of paperwork you filled out when you started your job was an Internal Revenue Service (IRS) Form W-4. This form determines how much money will be withheld from your paycheck each period.
The intent is for all the money withheld over the course of a year to work out to be about what you’ll owe in taxes on your wages for that year. When you file your tax return for the year, you either receive a refund check if your withholding was excessive, or you make up the difference if your withholding was insufficient. If your withholding was grossly insufficient, you may even be penalized and have to pay extra.
The majority of people receive a tax refund when they file their taxes, i.e., more was withheld from their paychecks than needed to be.
There are pros and cons to this. The main pro is psychological. People like getting money back once a year rather than having to send a check to the IRS. They don’t really notice paycheck to paycheck that, say, $10-$20 more is being withheld than needs to be, but they do feel good when they get a check once a year for a few hundred dollars.
If you get money back each year like that and you like it, there’s no reason for you to change anything. But there are certain cons to this as well, which may cause you to think about it differently.
One con is another psychological point. When people get money back in a lump sum once a year, it can feel like a “windfall” or “fun money.” They’re more likely to go off budget and not use it as wisely as they could. Whereas if they had that little bit more in their paycheck each week instead, they’d be more likely to use it more prudently to keep current with their bills, save, etc.
The main con, though, is economic. When you have more withheld than you need to from your paychecks, you are providing the government with an interest free loan. You would be better off earning off that money yourself. You could put it somewhere that earns interest, or if you’re carrying debt like credit card balances, you could put it toward paying those down. So you can either increase the interest you receive, or decrease the interest that you pay, either of which is better than simply giving the government the money to hold for you until April 15 each year.
So if you were trying to maximize your economic self-interest, you would aim for your withholding to equal what you owe in taxes each year so you come close to break even when you file your taxes.
Or really if you want to push the point, the ideal would be to reduce your withholding so that you owe as much money as possible each year when you file your taxes, as long as you don’t cross the line to where it’s enough that you’ll be charged a penalty for insufficient withholding. That way the government is lending you money interest free instead of vice versa. But you want to be careful with this if you’re not really disciplined about these things. It won’t help you to get your money early if you spend it unwisely and then have trouble paying your bill come tax time.
What many people don’t know is that they can amend their W-4 form at any time; it isn’t just a one time deal when you’re hired. You need simply let your employer know you’d like to change yours.
The easiest way to adjust the amount of withholding is to increase or decrease the number of “allowances” on the W-4 form. Most people just put down as their number of allowances however many exemptions they’re allowed when they file their taxes. That’s fine as a rule of thumb, or as a starting point. But if experience has shown that that number is resulting in your owing a lot of money come tax time, or receiving a big refund, you can change that number to change that result.
The higher the number of allowances, the lower the withholding. So in order to lower your withholding and lower your annual refund check, try adding one or two more to the allowances. In the less likely event that your withholding has been too low, try taking away one or two from the allowances.