Opportunity Cost and Income Tax Witholding

August 12, 2005

There’s a useful piece in this morning’s Inside Bay Area reminding readers that income tax refunds aren’t the “bonus” they’re commonly thought to be:

Getting a tax refund 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 withholding 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).

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