Savvy moves for tax refunds
Here's a way to redirect them for your retirement.
Mike Schupak gets an income tax refund almost every year. The 27-year-old employee of a New York City-based online retailer expects about the same as last year: $2,700. And what will he do with the windfall?
"I think I'll probably invest a third, put a third toward school loans and put another third in my bank account," he says. "For things like doctor bills, dentist bills — something always comes up once a year."
Smart guy. But Mike can go a step further.
It may feel good to get a refund — but it means you gave the government an interest-free loan last year. Why not adjust your federal withholding — the amount taken out of each paycheck to pay federal taxes — so the total amount withheld is closer to your actual tax liability? Here's why:
- It will increase the amount you see in your paycheck each month.
- You may get more out of that money by directing it to your employer-sponsored retirement plan, where it potentially can produce tax-advantaged growth. (Just don't cut your withholding so much that you owe taxes, or even underpayment penalties, at year-end.)
Pay what you owe—not more
To adjust the amount withheld, you'll need to determine the right number of federal withholding allowances to claim. Each allowance means more money in your paycheck.
First, figure out exactly how many allowances you should take. There are several online tools to help you do that, including the IRS Withholding Calculator and Bankrate.com's Payroll Deductions Calculator.
For example, say you are a single taxpayer earning $35,000 a year and you received a $700 refund last year — meaning you overpaid by about $58 a month. According to the Bankrate.com calculator, changing from one allowance to two will add about $46 to your monthly take-home pay. That's $552 a year — close to your refund amount. To make the change official, fill out a new Form W-4.
Put the money to work
One more step: Direct that money to your employer-sponsored retirement plan. Increasing contributions to your retirement account — even by just a little bit — can transform your financial future. And if you're already contributing the maximum to your retirement account, consider also funding an individual retirement account (IRA).
Fast Fact: How can a little extra make a big difference? Use the chart below to see the potential impact a small increase in retirement plan contributions could have on retirement savings for a worker with a $35,000 salary.
| Additional contribution | Reduction in take-home pay per week | Projected additional savings at retirement |
|---|---|---|
| 1% | $5.05 | $62,116 |
| 2% | $10.10 | $124,232 |
| 3% | $15.15 | $186,348 |
| 5% | $25.25 | $310,580 |
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