This 401k tax tip may be one of the most powerful ideas you share with your employees. With the tax deadline just passing and many employees deciding what to do with their refund, it’s a great time to teach a lesson in compound interest.
By now most employees will have filed their taxes and will likely be expecting a refund check from the US Department of the Treasury. The IRS reports that the average overpayment of taxes is approximately $3200, or $266 a month. That is essentially an interest-free loan to the government being made by millions of employees each year.
Instead of lending that money to the US Government, interest-free, wouldn’t that be better used in a 401k or other retirement plan? Especially for lower-wage workers who stand to benefit most by extra contributions, optimizing withholding can add-up to a lot of tax-deferred savings.
Instead of overpaying taxes, if a typical employee contributed that $266 of tax overpayment each month they would accrue a whopping $269,210 over a 30 year period (assumes 6% annual appreciation). If those payments increased at the rate of inflation (assume 2% per year), the savings balance grows to $333,215 at the end of 30 years.
The process is simple, but should be researched first to avoid withholding too little resulting in an underpayment by the employee. Plan Sponsors can begin by asking employees bring-in their recent tax forms for 2016. Then, using the IRS Withholding calculator, participants can get an accurate understanding of the correct number of deductions to claim on a re-submitted W-4 Form to reduce the withholding amount, freeing up the additional income for retirement contributions. And by contributing a higher amount, the employee realizes an even greater tax benefit by reducing their adjusted income.
If you are an employee, the Withholding Calculator can help you determine whether you need to give your employer a new Form W-4, Employee’s Withholding Allowance Certificate to avoid having too much or too little Federal income tax withheld from your pay. You can use your results from the calculator to help fill out the form.
CAUTION: This Withholding Calculator works for most taxpayers. However, if you owe self-employment tax, alternative minimum tax, or certain Other Taxes; you should use the instructions in Pub 505, Tax Withholding and Estimated Tax. –IRS Website