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All Else Equal, Tax Season a Good Time to Right-size your W-4 Withholdings

In Economy on April 12, 2015 at 1:39 PM

Here is a macro scenario for households looking to improve their financial positions – an “Operation Twist” on W-4 tax withholdings in order to free up cash for individuals. Imagine you are like the approximately 82 percent of households overpaying your tax withholdings to an April 15th refund of $3,000 yearly. You may believe you had completed your IRS W-4 withholding form correctly upon first glance. However, given this typical scenario, you, like the majority of Americans, have not. According to the back of my napkin, if you take 82 percent of the latest U.S. Census Bureau estimate of 118 million households in the country and multiply by the $3,000 estimated average refund, then the total dollar amount over-withheld from yearly paychecks in the U.S. is $290 billion.

All else equal, you can take this rough analysis a step further, and estimate some large dollar opportunities for improving household finances further. Assume a GDP per capita of $50,000 for average household income, or, more realistically, take median U.S. household income of $52,000 as reported again by the Census. Then consider standard lending underwriting metrics utilized by banks and credit unions in qualifying borrowers for a mortgage, e.g., the debt-to-income percentage (or “DTI”) and loan-to-value percentage (or “LTV”). If a lender is unwilling to breach advancing to you a debt underwritten beyond a 36 percent DTI and a 5 percent LTV, then you could adjust your W-4 tax withholdings in order to improve your financial plight. Once done, unqualified borrowers would move even closer to being qualified borrowers after paying down outstanding credit card balances by $250 per month, hence freeing up DTI capacity, and/or saving the $250 per month in order to be allocated toward a 5 percent downpayment on the purchase of a home and to cover the typical additional upfront closing costs of 3 percent when taking out a mortgage. Over time, with W-4 withholdings executed correctly en masse, household finances would steadily improve in aggregate; the only risk being under-withholding too much money from each paycheck and being shocked with a large bill to the IRS come April 15th.

“An ounce of prevention is worth a pound of cure.”

According to this CNN article, the typical household credit card balance is approximately $16,000 and “the average interest rate runs in the mid- to high teens at any given time.” Taking that knowledge and assuming a hypothetical interest rate of 13 percent, apply that rate to an otherwise unpaid amount of $3,000 in credit card debt each year, and that directly translates to $390 saved in accrued interest per year—which adds up over time in accumulated savings. Therefore, given the large numbers of households already “liquidity” constrained, student debt registering at unprecedented levels ($1.3 trillion as of 2014Q4), high-interest rate credit card debt still commonplace ($889 billion as of 2014Q4), and small & medium-sized enterprises (or “SMEs”) still strapped for credit relative to corporate firms (credit extended to corporations increased by 6.3 percent year-over-year as of end of year 2014, versus 5.3 percent for SMEs), right-sizing your W-4 tax withholdings in order to free up $250 per month is the obvious way to improved financial health, wealth and wisdom, to borrow from Benjamin Franklin.

According to official Federal Reserve statistics, households and nonprofit organizations reported assets of $97 trillion and liabilities of $14 trillion at year end 2014, that is, a ratio of 6.9, which represents a gradual improvement versus a ratio of 6.7 a year prior. Paying off high-interest credit card debt, say registering at an otherwise 13 percent APR for example, would save interest payments for households to the tune of $38 billion per year, i.e., a more than marginal improvement in the total household assets-to-liabilities ratio when considered over a series of years.

A lower DTI alongside a lower LTV almost guarantees that a household will move further from the brink of illiquidity and insolvency, i.e., in the direction toward a Gresham’s dynamic-free, anti-fragile, steady-state of the economy, wherein household net income and net assets are consistently positive over a prolonged period of time. From an accounting perspective, net income will always equal income less expenses, and net assets will always equal assets less liabilities, respectively.

Milton Friedman, the former Chicago University economics professor now deceased, and others appear to have largely solved the U.S. tax evasion issue by imagining and implementing a creative income tax withholding system using the W-4 process. A new goods & services tax (or “GST”) system proposed by Michael Graetz, a Columbia University professor of tax law, would supposedly shift the U.S. economy to an even less tax evasive structure and with more equity. Barring a grand fix, however, optimizing the current U.S. income withholding system will have to suffice in the short-run. Right-sizing W-4 tax withholdings would quickly aid the average household on the spot today (or, at least, come next paycheck), and in a practical, free-wheeling manner.

A penny withheld is a penny accruing interest, ceteris paribus.

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