What Are Tax Withholdings?
Taxes are complicated, but there’s a sneaky little trick we can learn from a boring thing like tax withholdings, and that’s how to painlessly save more money.
First, what are tax withholdings?
Tax withholdings are a chunk of money from each of your paychecks that gets sent to the government to be set aside as income tax for you.
When it comes time to pay your taxes, you’ve already filled up the bucket of what you owe because you’d been paying in drip-drop fashion throughout the year. If you get a refund, that means you filled up the bucket too much, and if you owe money, that means you didn’t fill up the bucket enough.
While taxes can seem boring, there’s something really powerful we can take from the way the government taxes us through withholdings.
Tax Withholdings are a Fairly Recent Phenomenon
Did you know that we used to pay our taxes once a year at “tax time?” Depending on your age, your grandparents or great grandparents may have lived in a time when there was no such thing as taxes being withheld from your paycheck.
Then, as a way to finance the war, the government began asking us to send in estimated tax payments (as part of our patriotic duty). People weren’t too keen on the idea. So the government began to offer incentives for doing so. Eventually the incentives became enticing enough that many started withholding their earned income. And from there we got to where we are now— being charged penalties and interest if we don’t pay as we go!
Tax Withholdings are a Brilliant Setup
How often do you take note of the amount of taxes that were taken out of your paycheck? Could you tell me, without looking, what that dollar amount is? Could you tell me, without doing the math, what that amount adds up to per year? You probably don’t have any idea—I know I sure don’t!
That, right there, is part of the genius of the plan. (That “small” amount of money is taken out of your paycheck before you ever see it, think about it, touch it or wonder what you might be able to do with it if you didn’t have to pay taxes.) The vast majority of people never even notice that it is gone. All that matters to us is how much gets sent to our bank accounts.
“But I Don’t Pay Taxes!”
Some people will say, “but I don’t pay any taxes!” Tax time is like a highly anticipated bonus that comes once a year, and they can’t wait to find out how much they are going to “get.”
That’s just not really accurate. Pretty much every single one of us will pay taxes! Every. Single. Year. We pay social security tax, federal income tax, possibly state income tax (except for the lucky few states that don’t!), and a whole slew of others.
If you’ve received a tax refund, you’ve essentially given Uncle Sam an interest-free loan with your money.
How Do I Change My Withholdings?
If you’ve gotten a tax refund or owe additional taxes, you’re at a great point to know if you want to adjust how much gets sent to the government each paycheck—those are your withholdings. Use a tax withholding estimator to figure out your tax liability when you file next year’s income tax return—whether you’re going to owe or get a refund.
Read more about the downsides of receiving a tax refund.
But there’s a more important concept at play here, and we don’t want you to miss it.
The Sneaky Brilliant Thing We Can Learn from Tax Withholdings
The government has figured out the best way to get us to put away 10-50% of our money without giving it a lot of thought.
Nearly all of us go along in life, planning our spending based on the amount of money that hits our bank accounts. We usually don’t even think about the money that we paid in taxes because we can’t get it back.
If taxes go up, we might feel a little frustrated, but then we forget about it and move forward. We make life work regardless of the amount coming out of our checks before we see it. This is the brilliance of tax withholdings. I truly believe that if everyone had to write a check once per year for the full amount of taxes that they owe, there would very quickly be a revolt.
Why don’t we use the same psychology on ourselves when it comes to saving? If we truly have our own best interests in mind, we should create our own “withholding” plan—but keep the money in our coffers!
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How to Use the Concept of Withholdings to Save More Money
Automatic savings plans are the best way that I have ever seen for people to put away a good amount of money. It's relatively painless and doesn't require a lot of thought.
You can set up a repeating, automatic transfer that sends money from checking to a savings account, a retirement account, or even just an account you don’t check regularly. Pick a set amount, set up a regular transaction, and let the automation do its magic.
If you want to make saving money easier, use the power of unseen, regular contributions to pay yourself. You might not even notice until you take a peek at your savings account balance and your jaw drops.
* This article is for educational purposes and should not be construed as tax advice. Before making any financial decision you should consider all factors and consult with a professional.