Increasing W-4 exemptions in case of potential inflation

[brian0918]

I am getting a relatively large amount back this year from the IRS, and would like to avoid that in the future by increasing my W-4 exemptions. I'm aware there are penalties if not enough taxes are withheld - isn't it a 5-6% penalty rate if you owe over $1000 on your return?

I'm curious what folks would do if major inflation was impending over the next year - wouldn't it make sense to claim too many exemptions and simply pay the penalties? Now I'm not saying you should go overboard and claim obviously high exemptions that will land you in jail (for up to a year) - although that too could be justified if, say, hyperinflation was impending. What do you think?

Edited January 17, 2010 by brian0918

[softwareNerd]

The penalty depends on how much under you pay. Also, if the income is irregular (e.g. a one-time payment, or a huge capital gain, say in Q3) one can pay nearer the point of receipt. I think it's called "Advance Tax" or something like that. The year is divided into sections and you are usually okay if you pay the advance-tax by a certain date for each section. If I remember, if you pay less than warranted by last-year's income, the penalty kicks in sooner. Not an expert...those are just a few conditions I've witnessed personally.

To tackle the substantial question, let's assume a penalty of 10%. While legally different from a loan, the math works like a loan. It would be like borrowing money at 10%...to do... what? That "what" is the key. If one is going to put it in an investment that earns substantially more than 10%, it seems worthwhile. However, the loan and interest are certainties, while the return is not. So, that has to be factored into one's judgement.

There is also the question of whether this is really your marginal dollar, and how it fits in to your overall approach. If, for instance, one keeps some funds in low-earning vehicles: e.g. CDs, bank-accounts, then one has to evaluate whether these are better sources of marginal investment funds, instead of borrowing @10%.

[brian0918]

In filling out my W-4, at the part where it has you convert a dollar amount into a number of exemptions by diving by $3650, and then dropping the remainder, I had to drop a pretty big remainder: .78. And that assumes state/local and real estate taxes won't go up, which they have been substantially. I'm thinking I will simply increase the exemption by 1 and likely pay some back to the government on the next return, rather than lose out on the potential interest I could gain over this next year, either through investments or as a hedge against inflation.

Edited January 17, 2010 by brian0918

[khaight]

In filling out my W-4, at the part where it has you convert a dollar amount into a number of exemptions by diving by $3650, and then dropping the remainder, I had to drop a pretty big remainder: .78. And that assumes state/local and real estate taxes won't go up, which they have been substantially. I'm thinking I will simply increase the exemption by 1 and likely pay some back to the government on the next return, rather than lose out on the potential interest I could gain over this next year, either through investments or as a hedge against inflation.

If you really want to stick it to the government, you should crank your exemptions up to the legal maximum and make explicit estimated tax payments each quarter to provide the maximum possible delay before delivering your hard-earned wealth to the government. That is living on the edge, though -- you have to be damn sure you're calculating your aggregate tax liability correctly. Several years ago I worked out a spreadsheet that does a pretty good job of tax estimation for people in basically 'normal' situations, i.e. income from salary, ESPP and stock option exercises, deductions for mortgages, charitable contributions and state tax payments. Then again, I'm a geek.