Are You Managing Your Withholding Wisely?

Dear Carrie: I get a big tax refund every year. Is it better to invest it, pay off debt, or save it for a rainy day? -A Reader

Dear Reader: Your question certainly hits three of the top ways to make the best use of any extra cash. Which to focus on first-investing, debt reduction, or savings-depends a lot on your overall financial picture, and I'm happy to give you some guidelines. But before we get into how to prioritize where to put your money, I think you need to look at your tax situation and determine if you're managing your withholding properly.

 
Review Your Withholding

When you start a new job, your employer has you fill out a W-4 form, which helps the employer figure out how much federal income tax to withhold from your paycheck. On this form, you claim a certain number of withholding allowances. The more allowances you claim, the less income tax will be withheld from your paycheck. If you're getting a big tax refund every year, chances are you've claimed too few allowances on your W-4.
While you might view a big refund as a good thing, there's another way to look at it. By having too much withheld, you're reducing your take-home pay and in effect, giving Uncle Sam an interest-free loan with money that could be in your own pocket each month.

Make a Change in Your W-4 if Necessary
If you'd rather have that extra money in your paycheck, all you have to do is complete a new W-4 and submit it to your employer. The withholding calculator at IRS.gov can help you determine how many allowances to claim for your current situation. To use the calculator, it's best to have your most recent pay stubs and income tax return handy. Once you have the new information, you can download a W-4 from the IRS website. And you don't have to wait until the end of a tax year to make a change. You can give the new W-4 to your employer at any time. You might also want to run this new scenario by your tax advisor.

Get Down to Fundamentals

Whether or not you decide to make a change in your future withholding, you're smart to be thinking about where best to put your money to work. While you mention three important categories, I'm going to add a fourth and actually make it No. 1 on my list of suggested priorities. I consider all of them fundamental to good money management.

1) Focus on your future by making sure you're contributing enough to your 401(k) to capture any company match. You might consider this an extra bonus beyond your tax refund.

2) Next, zero in on your debt. If you have credit card balances, pay the higher interest cards first, then work your way down with the ultimate goal of paying everything off. At the same time, make a promise to yourself to try to keep credit card debt at zero.

3) With your debt under control, prepare for that rainy day. Make sure you have an emergency fund to cover at least three months essential expenses. You don't want to be financially derailed by the unexpected.

4) And finally, when you have your credit card debt and your emergency fund covered, it would be time to invest your tax refund for longer-term goals.  If you're new to investing, first look at how much risk you're comfortable with and start with something like a broadly diversified mutual fund or exchange traded fund.

Look at the Bigger Picture

So far we've been talking about specifics, but to really take charge of your money, I suggest you take a step back and look at your complete financial picture. For instance, are you being realistic about how much you need to save for retirement? Do you have a plan to achieve your other goals-for example, a house, a child's education, or a special vacation? Do you have the right kind of insurance coverage, from health insurance, to possibly life insurance if you're married and have dependents?

It's great that you want to use your tax return wisely, but rather than making just a one-time decision, I'd use this extra money as an impetus to focus on how you can make smarter financial moves year round. You sound like you're on the right track.

Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNERT, is president of Charles Schwab Foundation and author of "It Pays to Talk." You can e-mail Carrie at This email address is being protected from spambots. You need JavaScript enabled to view it.. This column is no substitute for an individualized recommendation, tax, legal, or personalized investment advice. © 2012 CHARLES SCHWAB & CO., INC. MEMBER SIPC

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