When you work for a company that manages its payroll properly, federal and state taxes are withheld every pay period. The companies estimate your total tax bill based on your annual salary and divide that amount by the number of pay periods within the year. They get some help from the W-4 form you filled out when you were hired, which includes important tax information like your filing status and the number of claimed dependents.
This calculation almost never works out well. Either you don’t pay enough tax throughout the year, thanks to, among other possibilities, income you receive unknown to your company, or you pay more than you owe, thanks to deductions unknown to your company.
Banking Deal: Earn 1.20% APY on an FDIC-insured savings account at Barclays.
This underpayment or overpayment results in tax due to the IRS or a refund due to you. These differences are reconciled when you file your taxes.
You know all this, but the basics bear repeating in order to pose this question. Since it’s almost impossible to predict to the penny how much tax you will owe, is it better to err on the side of black or red? That is, is it better to owe money to the IRS or allow the IRS to owe money to you?
Owing money to the IRS for underpayment of taxes
If you have to write a check when you file your taxes, it means you got to use or keep and earn interest on the government’s money throughout the year. That’s not a bad thing; it’s like an interest-free loan. However, if you don’t plan, you could end up owing money that you don’t have, causing a major cash flow problem. If you underpay significantly, you could end up owing penalty fees as well.
Expecting a refund from the IRS for overpayment of taxes
If you receive a refund, you gave the government an interest-free loan throughout the year. Politicians will be happy to take your money to fund various programs while you work, but it doesn’t have to be that way. By not keeping money that is rightfully “yours,” you lost the opportunity to invest and earn interest on that cash. However, there is a psychological advantage to receiving a check from the government.
Not only that, but overpayment of taxes can act as a “forced savings plan,” albeit not a very good one. The forced savings can be beneficial to anyone who struggles with spending less than they earn.
I would prefer to owe the government money when it comes time to reconcile tax liability every year. The benefits of using the government’s money for free outweigh the benefits of letting the government hold my money, at least for me. I think most Consumerism Commentary readers, who probably have no need for a “forced savings plan,” would agree. But I’d like to hear other opinions, so feel free to share your thoughts.
This post is a part of the MoneyBlogNetwork Group Writing Project focusing on taxes. Here are the contributions to the writing project so far: The Value of Doing Your Own Taxes (Five Cent Nickel); My Best Piece of Tax Advice (Free Money Finance); Mr. Lawyer and Mr. Accountant Chat About Taxes (Get Rich Slowly); A tax tip from my pastor (Mighty Bargain Hunter); A Taxing Situation – My Biggest Financial Regret (No Credit Needed); Certainties: Death, Taxes, And Change (Wise Bread).
Updated October 16, 2015 and originally published March 3, 2008.