Stop Loaning Uncle Sam Money

Stop Loaning Uncle Sam Money

I remember thinking of income taxes as this magic art that only my mother, with her copy of TurboTax, could figure out for me and my siblings. She would buy the software every year and then run our numbers through the program and figure out what we owed. Most years it was nothing or a small (under $50) refund. One year I made the mistake of letting a few venues pay me directly with checks for gigs that the band I was in would play. But other than that, filing my annual income tax return was beyond my knowledge and for the most part, beyond my concern.

The years past, I met my wife, we had a son and we began filing our own taxes, bouncing between different tax software solutions, still admittedly befuddled by the litany of questions that they would ask us. Since we had a child and unknowingly claimed 0-1 dependents (we could never remember once we filled out our W-4, which one really only does when starting a new job) we always got a pretty big refund come tax time. We usually got around to doing our taxes well before April 15th but we were never in a rush to do them – we were a young couple, figuring out our place in life and how to raise a child.

This continued on pretty much until a year or so ago without either of us really taking the time to understand how the withholdings from our paycheck and the deductions and tax credits all work together. We just knew that it was safer to pay what we were paying out of our paychecks than to roll the dice and have to owe taxes. We generally expected to get a $2,000 – $3,000 refund every year and were never really surprised by the amount that we got.

Once we got really interested in financial independence, I began to delve deeper into how income taxes were calculated and how, at it’s core, it’s not really that complicated.

  1. Gross Salary – Tax-Deferred Contributions (401k, HSA, Pension, etc.) = Total Salary / AGI (in basic cases)
  2. Adjusted Gross Income – Deductions = Taxable Income
  3. Plug Taxable Income into our tax brackets (use an online calculator) to get Tax Due Before Credits
  4. Tax Due Before Credits – Tax Credits = Tax Liability
  5. Tax Liability – Tax Withheld / Paid = Tax Due or Refund Due

The problem we were running into was that, having children and keeping our allowances at 0 or 1, we were essentially giving the government a 0% interest loan of $2-3K every year. We could have been getting more of that money piecemeal in our paychecks rather than waiting until 3 – 14 months later (assuming we filed and received our refund in March for the previous year).

Now why does this matter? Well for two reasons – inflation and opportunity cost. Even down to monthly data, prices go up with inflation. Generally speaking, something that cost $1.00 in January 2017 will cost $1.02 in January 2018. That doesn’t seem like much, but let’s say for tax year 2017 you were due a $3,000 refund. When you file and receive your refund in March 2018, you are still getting $3,000 put it’s purchasing power is (slightly) reduced. The government received your money months earlier than it legally needed to and you got nothing but less purchasing power out of this arrangement.

In fact, you lose the ability to use that money sooner. This math works out even less in your favor when you factor in that you lose the ability to invest – and possibly grow – that money.

Thankfully, there is a way to remedy this situation – adjusting your personal allowances via Form W-4. Let’s run through some scenarios.

Note: All scenarios are using 2018 tax numbers.

Single Filer, No Kids

Let’s take this single worker with $55,000 of gross annual W-2 income (aka wages) – let’s call him Jeremy. Jeremy gets paid 24 times a year – twice a month or “Semi-Monthly”. Jeremy wisely decides to max out his 401k contributions for the year, so that reduces his Adjusted Gross Income (AGI) by the full $18,500. Jeremy doesn’t do anything special tax-wise, so he isn’t itemizing his deductions, so he takes the standard deduction of $12,000, lopping that off his AGI to give him a taxable income of $24,500.

Now, you may be thinking “Hold on a minute. Why would Jeremy reduce his income by $18,500 when he is already making such a low salary?” Plugging $55,000 into this paycheck calculator for Harrisburg, PA, 1 federal allowance and $770 401k contribution per paycheck gets us $1,134 per pay | $2268 per month | $27,216 per year. I will say that this calculator kind of goes sideways and adjusts state and local taxes to exempt 401k contributions (which just isn’t the case in Pennsylvania) but that’s a nominal difference to the final result. To complete this tangent – it is certainly possible for a single person to survive on $27,000 per year. This blogger did it with a family of 3, and this blogger did it with a family of 5.  


Back to the calculations – Jeremy has a federal taxable income of $24,500 and when we throw that into our tax brackets that gets us $2,750 of tax liability. Jeremy does not have any kids and he didn’t do anything out of the ordinary like buy an electric vehicle or install solar panels. So his total tax liability stands at $2,750.

If Jeremy sets his personal allowances at 0, he will then be withholding $156 per paycheck, or $3,744 every year. Jeremy will get a refund of $994 and will get a take home pay of $1,113 per pay period. If prior to the tax year in question, Jeremy instead changed his personal allowances to 2, he would then be withholding $115 per paycheck and would be getting a $10 refund. He would then get a take home pay of $1,155, about $42 more per pay.

That $42 could then be used to pay down debt or invest carefully in the stock market or real estate, building Jeremy’s net worth along the way. For example, using 2017 numbers, if Jeremy invested that $82 more dollars per month in Vanguard’s Total Stock Market Index Fund (VTSAX), that would have grown into roughly $1,122 over the course of the year. Meanwhile the $994 he receives in March 2018 would have less purchasing power than it did over the course of 2017.

Note: I will admit that 2017 was quite the anomaly of a year in terms of growth, but it was the most recent full year available with data.


Married Filing Jointly, No Kids

Harry and Sally are married and have no kids. Like Jeremy, they too each make $55,000 annually, get a paycheck 24 times per year and max out their 401ks to the IRS limit of $18,500 per year each. As shown in our table below, using the standard deduction ($24,000 for married filers), they have $49,000 in taxable income. This results in a tax liability of $5,499.

Using the same salary calculator mentioned above (set to Harrisburg, PA and maxing out 401k contributions $770 per paycheck, with personal allowances at 0), they would withhold $5,232 combined. There’s admittedly not much to work with here. Even setting their allowances to 0 results in them owing in the neighborhood of $270 for the year. This is largely because they aren’t claiming any credits, as we will see next.

Married Filing Jointly, 1 Kid

Using the same situation as above, let’s say Harry and Sally have one child. If this child lives with them, is their dependent and is under the age of 17 at the end of the tax year, they now get to claim the Child Tax Credit (CTC) for them. Side note: It’s important to not confuse the CTC with the EITC. The CTC phase out for 2018 is $400,000 for married, filing jointly so we should be good for this example.

Claiming their child for the CTC on their income taxes, reduces their tax liability from $5,499 to $3,499. Knowing this, they could change their allowances to 2 thus withholding $3,312 for the year in federal taxes for the both of them. This would put their per pay period take home pay at $2,400 – a $80 increase (the both of them combined) per paycheck over setting their personal allowances to 0.

That extra $160 per month, using the same VTSAX numbers from above, could grow into $2,137 over the course of the year.

Harry and Sally Have More Kids – A Summary

The following table highlights the scenarios for the Harry and Sally, with same situation as above, just changing the number of dependent children.

As you can see, given their income, once they get above 2 children, they are getting a refund no matter what. Not only that, they are not withholding any federal taxes from their paychecks.


Now all of these scenarios are very specific, where both spouses work and bring in the identical amount in income. But it serves to show the power of knowing just a little bit about how income taxes work and what effect that can have on your take home pay.

In closing, my own personal experience is that that when presented with a lump sum of money (say $3,000 from a tax refund) I am more prone to take the approach of “What extra special thing am I going to buy with this extra money?” Anecdotally, I have heard many of my peers share the same feelings. Getting a little bit more piecemeal every pay though, it doesn’t seem like much at the time and it’s easier to just apply it to debt or savings goals and move on with my day.

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4 thoughts on “Stop Loaning Uncle Sam Money

  1. Since we’ve been married, we have only had to pay IN taxes at the end of the year! The pay in is usually around $1k and we have a separate savings account for taxes. Instead of loaning Uncle Sam, we get a interest free loan!