Don't sabotage your retirement to give yourself a "tax cut"
March 11, 2013
Americans breathed a collective sigh of relief when the nation avoided a "fiscal cliff" budget debacle on January 1. For many of us, though, relief turned to annoyance when we got our first paychecks of the new year ... and noticed an increase in Social Security payroll withholding.
Some background: Two years ago, the Social Security tax rate for workers decreased to 4.2% as a temporary "tax holiday" to boost the economy. However, as part of the fiscal cliff compromise, the rate returned to the original 6.2%.
Why you shouldn't celebrate a tax refund
Did you receive a refund from the IRS this year? If so, think twice before you celebrate your good fortune. Here are three simple suggestions for putting your money to work.
In 2013, the tax applies to earned income of up to $113,700. For someone who earns $50,000 this year, about $1,000 more—around $20 more per week—is being deducted from wages.
If you're on a tight budget, you might be thinking about cutting back on your retirement savings to make up for that lost income. But before you do, ask yourself if you're saving enough for retirement to begin with. If not, saving less today could create a major financial problem tomorrow.
"It might be tempting to cut back on savings as a quick answer to higher Social Security taxes," said Maria Bruno, a senior analyst with Vanguard Investment Counseling & Research. "But it's amazing how just one or two percentage points of savings can compound over time."
Consider this hypothetical example: Sue, age 30, earns $60,000 a year. Right now she saves 6% of each paycheck for retirement. Assuming she earns a 6% average annual return, Sue's account could be worth $239,000 at age 67. But if she were to slash her withholding to 4%, her savings would be worth only $159,000 upon retirement—an $80,000 difference, all because of a seemingly minor decrease in her savings rate.*
Another option: Check your withholding
If you got a pay increase as of January 1, the Social Security tax hike might not have reduced your actual take-home pay. But if not—or if you're just trying to get a better handle on your finances—you may want to take a close look at the amount you have withheld from each paycheck for federal taxes.
According to the IRS, more than 104 million Americans received federal tax refunds in 2012, with the average refund exceeding $2,700. If you're expecting a significant tax refund this year, consider filing a revised Form W-4 with your employer to have less money withheld from each paycheck. The more allowances you claim, the less of your pay will be withheld from each paycheck for taxes.
Of course, if you do that, you might not get a tax refund in 2014. You might even owe money. But look at it this way: A refund isn't a gift from your generous Uncle Sam. In effect, it's an interest-free loan you gave the government. Wouldn't you rather keep that money in your paycheck—or put it to work in your retirement portfolio—instead?
* This example assumes Sue earns a 6% average annual return on her investments, has no current savings, no employer contributions, and retires at age 67. Final balances are shown in 2013 dollars. The results shown are hypothetical and do not represent an investment in any particular mutual fund. Use our interactive calculator to see how raising or lowering your savings rate today could affect how much income you have in retirement.
- This article is not intended to and does not constitute legal or tax advice. Vanguard suggests that you consult a professional about your own tax situation.
- All investing is subject to risk, including possible loss of the money you invest.