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Opportunity Cost and Income Tax Witholding

1 min readBy: Andrew Chamberlain

There’s a useful piece in this morning’s Inside Bay Area reminding readers that income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. refunds aren’t the “bonus” they’re commonly thought to be:

Getting a tax refundA tax refund is a reimbursement to taxpayers who have overpaid their taxes, often due to having employers withhold too much from paychecks. The U.S. Treasury estimates that nearly three-fourths of taxpayers are over-withheld, resulting in a tax refund for millions. Overpaying taxes can be viewed as an interest-free loan to the government. On the other hand, approximately one-fifth of taxpayers underwithhold; this can occur if a person works multiple jobs and does not appropriately adjust their W-4 to account for additional income, or if spousal income is not appropriately accounted for on W-4s. may seem like one of the more pleasant rites of spring. It may even seem like you’re taking the government for a ride, what with that pile of money you’re getting.

But that’s really not the case, say tax experts who advise workers to take advantage of a tax-planning strategy that will give them more take-home pay over the course of a year as opposed to a big refund once a year. The idea behind the strategy is to lower your federal income tax withholdingWithholding is the income an employer takes out of an employee’s paycheck and remits to the federal, state, and/or local government. It is calculated based on the amount of income earned, the taxpayer’s filing status, the number of allowances claimed, and any additional amount of the employee requests. rate, which will result in higher take-home pay. The extra money could then be invested in an interest-bearing savings account. Or you could use it to pay bills…

“The more allowances you claim, the lower your withholding, so the higher your paycheck will be,” said Jackie Perlman, senior tax researcher for H&R Block.

“When you get the big refund, you’ve loaned the government your money all year. They are holding your money all year and paying it to you in April of the next year,” said Mary Kay Foss, a partner at Danville-based accounting firm, Marzluft, Tulis & Foss CPAs. (Full piece here.)

As the authors note, the larger the refund, the larger the opportunity cost you’ve incurred by loaning payroll taxes to Uncle Sam at a zero interest rate all year.

In 2002, the Tax Foundation estimates the opportunity cost of federal income tax withholding was roughly $23.4 billion (for the calculation, see page 8 here).