What Are the Disadvantages of Withholding Taxes?

According to the Bureau of Labor Statistics “there are 75,609,000 workers in the U.S. who are paid wages or salaries at an hourly rate (or 60.2% of the total U.S. workforce of 125+ million in 2005.)” Many of these workers have taxes withheld from their paycheck to avoid a tax bill. While tax withholding is a popular system for wage earners, there are several disadvantages to consider.

Tax withholding is based on the living status of the individual worker. Because it does not take into account several deductible expenses (such as working costs, charity contributions and other deductibles) the IRS takes out the maximum amount, leaving less in the taxpayer’s paycheck and giving the government more money to work with throughout the year. For single workers with no dependents, this can mean up to 33 percent of the paycheck is taken out before the employee sees any money. This situation is resolved at the end of the year with a tax refund which can be obtained by filling out a tax refund sheet and itemizing your deductibles. Opting out of tax withholding gives employees more of their money in their paycheck.

While tax withholding usually prevents any difficulties with the IRS during tax season, storing the money in an interest-bearing account instead would allow you to profit from the money while still setting it aside for the government at tax time. Additionally, investing the money in a mutual fund or stock index can show you even more profits before tax time. A Roth IRA, for example, allows the money to be invested with a potential for tax deferred growth. There is inherent risk in stock investment, though, and it is worth noting that invested money may not be there at tax time to pay the tax bill.

While there are disadvantages of withholding taxes for the wage earner, businesses are also left with some drawbacks. Because of the individualized nature of withholding tax, the work of paying out employees has become a specialized skill. To limit liability and reduce overall staffing costs, many companies subcontract their payroll to special payroll companies. While this practice can lessen the financial burden of increased bureaucracy due to tax withholding, it also puts control of employee paychecks in the hands of a third party, making mistakes harder to rectify.