Pay Yourself First Under Withholding Tax

Some people don’t have the financial discipline to carry out a plan of under-withholding taxes. Some people don’t have the financial cushion to carry it out to make a difference. However, if you have both, you can use under-withholding to your advantage.

Is under-withholding illegal? No. Unlike estimated tax payments, which go towards a specific quarter and due on the 15 of April, July, October, and January for the following year, the tax withheld from your paycheck is calculated as if the entire withheld amount is contributed throughout the entire year. What does that mean exactly? It means that whether you pay your tax out of your paycheck in January or December, they’re treated exactly the same by IRS, as if every 1/12 of the amount was paid evenly every month throughout the entire year. Knowing this, why would you want to pay IRS in January when you can pay IRS in December? You can almost put the amount in a 11 month CD, and get some 4% to 5.x% interest out of it.

I personally have carried out this practice for several years now. I under-withhold my taxes throughout the entire year, and I start to check on the exact amount of taxes that I should be paying in around October. The bigger amount you under-withhold, the earlier before year end that you should check on your taxes. The reason is that if you don’t start planning early enough, you may not pay enough taxes for the whole year, even if you send your entire paycheck to IRS for the last month in December. Essentially, you want to pay just enough taxes in a year, as not to trigger a tax penalty, and you want to pay more of your taxes near the end of year, instead of the beginning of the year. Calculating how much taxes you should pay can be very complicated. It’s also different for people whose adjusted gross income in the last year exceeded $150K. But you can easily figure out the underpayment taxes using my 2006 tax calculator. The calculation of underpayment taxes have taken into accounts for all of the conditions listed by IRS. It is the amount of additional taxes that you need to pay in order to avoid any tax penalty assessment. You don’t need to work through any IRS rules. Just enter all the numbers, and it will tell you how much more in taxes you need to withhold or pay.

To under-withhold or pay additional amount of taxes from your paycheck, you can simply fill out a W-4 form and give it to your payroll department. Besides under-witholding your taxes, another trick that you can play is over-contributing to your 401K, so that you can put in most of the contribution dollars upto the maximum earlier in the year, instead of later. For more details, you can find them at my other post “How I earn extra 1.45% return without risk in my 401k account”.

To summarize and put your cash flow into timeline, here is the picture of “paying yourself first” if you have utilized both early 401k contribution and under-withholding taxes:

  1. If you make early 401k contribution, the first 3 to 4 months are the months when you will be paying into your own 401k account. Your net cash from paycheck will be tiny. You will be paying mostly the payroll taxes (social security and medicare taxes), but not much income taxes.
  2. Then from March/April to probably October, these are your golden months for cash flow. Since you’re done with your 401k contribution, plus that you are under-withholding income taxes, your net cash from paycheck will look really good. But obviously, it’s not the time for you to spend those cash. Rather, you should be saving or investing those cash and prepare for the upcoming November/December and also till next year of April if you’re doing early 401k contribution every year.
  3. November and especially December will literally be the dry months. If you have executed your under-withholding plan perfectly, you should be paying your entire paycheck towards IRS at the end of year. That means that there is $0 or close to $0 cash flow from your paycheck. You will need to be surviving from cash accumulated in the previous boom months of either January through October, or March/April through October if you contribute early to 401k.

Too complicated for you? Hey, if you know any ways to save or earn more money without any work, please let me know. To get something in return, you always need to pay at least a little bit of effort, whether it’s planning your cash flow, reading books or articles, etc.

Here is an article “Get next year’s tax refund now” from MSN money that talks about under-withholding taxes. It should supplement and reinforce this “tax saving” tip.

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