Tax Witholdings and Savings Questions

Recently, a reader of Money360 ed me with an interesting question about tax withholdings:

With the tax year over, we get to see what we owe the IRS and the State in taxes. Normally we have our employers withhold amounts and send them to those entities, where they sit doing nothing. Alternatively we could withhold nothing, and instead set that money aside in (for example) and HSBC Direct account. This could potentially be a lot of money gaining interest for you, rather than sitting in the government’s coffers doing nothing.

Obviously the trick is to actually set that money aside and not spend it, and then to set aside at least the correct amount. I’m pretty sure I’d be safe using the previous year’s taxes due as a good estimate. Just wondering what you and/or your readers might think of this.

If you look at this situation with some huge blinders on, then my reader is absolutely correct. You can keep your own tax withholdings, invest them yourself, and then just write a check for your income tax. Look at the federal taxes withheld on your last pay stub for the previous year; you could easily earn another 2.5% on that amount for your pocket before you even write a check for taxes.

But let’s take the blinders off and realize the truth: you are opening yourself up to a huge amount of risk by doing this. How?

You’re relying on your own calculations of what you’ll need for your income tax. You could use your previous year’s amount as a guideline, but the truth is that if there are income tax changes or changes in your own income, that amount is going to change and could change drastically. If you make a mistake here, it could be a big problem come tax time.

You’re taking money that is effectively untouchable and making it easily accessible. Suddenly, that money which you couldn’t touch before is suddenly sitting there in a savings account. Thousands of dollars. Can you resist the temptation to withdraw a little for a big date, or for a new refrigerator? Suddenly, you find yourself on tax day without enough money to cover the account.

The IRS is not impressed if you “don’t have money” to pay your taxes. The penalties for messing this up are severe: the IRS isn’t a patient and friendly organization and they will go after you if you don’t have the cash to pay.

These are significant risks that you should never overlook when considering such a thing. Because of these risks, I don’t recommend following this plan; you take a situation where your taxes are covered and turn it into a situation where there is risk. Given the penalties, that risk simply isn’t worth it.