Don’t Use The IRS As A Piggy Bank: Tax Withholding vs Tax Liability

tax liability vs tax withholding

Don’t Let The IRS Be Your Savings Account

Do you like using the federal government for your savings?

If the answer is no you may want a better understanding of tax withholding vs tax liability as it relates to your paycheck.

The truth is the government pays you an astounding 0% annual interest return on your money, and yet many of us still use the IRS as a short-term savings account only to feel like the government is giving us a big BONUS the next spring when we complete our tax return.  Many of us that are not certified public accountants (CPA) are afraid to leave ourselves short at the end of the year so we over compensate on our tax withholding because we are not sure of our tax liability for the year.  The evidence comes when you ask someone what kind of refund they received from their tax return for the previous year (if they will tell you).

If the answer is over $300 the government is basically acting as their piggy bank.

Some people fully understand what the IRS is doing, and they do not trust themselves with the extra money.  That is totally fine, but I would prefer them to at least know what is happening each paycheck.

WARNING:  I am not a CPA or tax attorney so consult a professional on the best ways to properly manage your finances and income tax decisions.

 Tax Withholding vs Tax Liability

The IRS states that “the federal income tax is a pay-as-you-go tax”.  The government basically allows you 2 ways to pay as you go.  If you are an employee, your employer more than likely withholds income taxes from your paycheck.  This is tax withholding.  The amount that is withheld is paid to the IRS in your name.  It is basically earnest money paid towards the tax liability you are incurring for the year.  Tax liability is how much you actually owe the federal government after you file your official tax return each year.  Since you don’t file a tax return after each paycheck or month (unless you are an employer filing tax and wage reports), the tax withheld each paycheck is really just an estimate of what you think you will owe the IRS for that pay period.

Estimated tax

On the other hand if you are self-employed or receive what is called 1099 income, there is no tax withheld from your earnings.  Therefore, you must pay estimated tax.  This concept is similar to tax withholding, but it is managed by you and is used to pay self-employment taxes and alternative minimum taxes in addition to income taxes.  People in business for themselves usually pay estimated tax.  Other types of income like rent, royalties, capital gains, and dividends may require you to pay estimated tax.

Regardless of how you withhold taxes from your paycheck or earnings you should maximize the amount of your take home pay if possible by minimizing your withholding each pay period.

If you pay mortgage interest, have student loans, or have dependents such as children you may be able to itemize tax deductions on your tax return reducing your tax liability (how much you actually owe).  I like to use the less than $300 rule for how much of a refund you should receive each year after you file your federal tax return.

If you can afford to pay a small amount to the IRS each year when you file you have given the IRS zero dollars to hold in their 0% interest bearing savings account.

Check out this withholding calculator to determine how much you should withhold from your paycheck.

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