The current tax withholding system is relatively modern. While withholding started with the imposition of the income tax in 1913, it was repealed three years later. The federal government's need for large sums of income due to the combination of New Deal expenses and World War II led to a resumption of withholding in 1943.
But to the government's advantage, modern-day withholding brings some disadvantages to taxpayers. Any money that's withheld from your paycheck represents a short-term loss of income, which also represents money that you could invest during the year to earn interest before paying your annual tax bill.
Cons of tax withholding include a short-term loss of income, loss of investment interest income, sticker shock if you owe extra taxes and a disconnect from your annual salary.
Short-Term Loss of Income
When money is withheld from your paycheck, you're giving the government an interest-free loan. Even if you aren't over-withheld, if you had the use of that money until the end of the quarter, as a self-employed person would, you'd probably be able to make better use of it. You could invest it for the short term or use it to pay down debt, reducing the amount of interest you have to pay on the amount of money that you owe.
Loss of Investment Interest Income
If you get a tax refund, it means that you allowed the government to take too much money out of your paycheck. While there may be some room for debate as to whether accurate withholding is an interest-free loan to the government, it's undeniable that over-withholding is. When you put too much money in your January 1 withholding and you don't get a refund until April of the following year, you're missing out on the opportunity to earn interest on that money for 15 months. Even if you use your over-withholding as a savings plan, you'd still do better if you were able to invest the money.
Sticker Shock from Under-Withheld Taxes
While under-withholding is a good deal from a financial perspective since you're keeping your money for a longer period of time, it can be a hardship for people that don't have extra money come April 15. If you have a life change that increases your tax liability – like getting divorced or earning unexpected money from outside of work – you'll probably owe money when you do your tax return.
Given that withholding is billed as a pay-as-you-go system that lets you essentially forget about paying your taxes, a bill in April can be an unexpected shock. Furthermore, if you're egregiously under-withheld, you could end up paying penalties and interest on what you owe.
A Disconnect from Actual Salary
With withholding, your money goes to your taxes as if you had never earned it. You don't ever see your true salary – you just see your net pay. In the minds of some political thinkers, the painlessness of paying taxes masks the true cost and cons of income tax. They argue that if every American had to write a check every quarter, as self-employed people do, they'd be less willing to support the current income tax system.
Benefits of Tax Withholding
Tax withholding enables the government to get a steady stream of income throughout the year, as employers and self-employed people generally remit tax on a quarterly basis, and it makes it less likely that people would spend too much money and be unable to pay their taxes. It also means fewer people can deliberately evade tax, since the money is taken directly out of their paychecks.
Tax Law Changes
Tax withholding isn't likely to go anywhere soon, but many taxpayers will owe less tax in 2018 and 2019 than in previous years thanks to changes in the tax law. In particular, income tax rates are decreasing for many taxpayers and the standard deduction is increasing. Check with your employer to see how your withholding amounts may change for the current year and make sure your withholding forms are up to date.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.