Why the ‘You Just Gave Uncle Sam an Interest-Free Loan’ Argument Doesn’t Work For Many Transitioning Military

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Executive Summary

Every year at tax time, you see pundits talk about ‘giving Uncle Sam an interest-free loan.’  While the concept of lowering tax withholdings is sound, there are several problems with its practice.  In this article, we’ll discuss:

  • The ‘common’ wisdom behind this interest-free loan concept
  • The major problems with its practical application during transition
  • Situations in which this is actually wrong

The Concept of ‘Uncle Sam’s Interest-Free Loan’

What is a ‘interest-free loan?’  In order to answer this question, we need to look at how we pay taxes.

Most people work for an employer as W-2 employees.  Throughout the year, our employer is responsible for withholding some of our compensation to pay estimated taxes.  The employer is then responsible for remitting them to the Internal Revenue Service (IRS) on our behalf.

Every year, (no later than January 31 of the following year), employers must issue a Form W-2 to each employee.  This form reports the same information to both the IRS and the taxpayer.  Included in this information is the amount of taxable income the company paid, as well as the amount of money withheld for taxes.  The employee then uses this information (as well as information from other sources) as the basis for their tax return.  The tax return helps to calculate your tax liability (your actual tax bill) and compares it to what you’ve already paid.  The difference is your tax refund (if you’ve paid more than your tax liability) or a bill on taxes you may still owe.

Your refund is simply a return of some of the money collected over the course of the year.  Since the IRS does not pay interest on your refund, you could view this as an interest-free loan.

The Proposed Solution to ‘Uncle Sam’s Interest-Free Loan’ and its Challenges

Now that we have a better understanding  of the interest-free loan concept, the answer seems pretty clear:

If we reduce the amount of money we pay the U.S. Government during the course of the year, we can reduce the amount of our interest-free loan.

What’s Wrong With this Solution?

While everyone might want to hold on to as much money as possible, it's best done when your income is stable.  During your transition, there are a couple of problems with this.  Let’s take a look:

Challenge #1:  While we can control how much our employer withholds, it's a challenge when you're changing employers.

Employers are responsible for withholding taxes.  To help employers withhold the right amount, the IRS prescribes guidance.  This guidance, in the form of withholding tables, that state exactly how much the employer should withhold and remit to the IRS.  The only lever that an employee has is by declaring the number of dependents they have in their Form W-4, and following the guidelines.

Form W-4 is the form that each employee uses to inform the IRS about how many dependents they support.  The employer uses the number of dependents annotated in the employee’s Form W-4 to determine withholdings from the IRS tax tables.  As a rule of thumb, the higher the number of dependents, the lower the monthly withholding figure.

You cannot claim more in allowances than the W-4 worksheet allows.  However, the worksheet allows you to claim allowances based upon earned income tax credit and other income-based adjustments.  You may be well served using the withholdings calculator to see whether you should make changes to your W-4 based upon your tax situation.

However, there are many nuances in the IRS guidance that can easily be overlooked.  As you transition, your income will probably fluctuate.  As it does, you may very well be caught off guard by the impact these changes have.

Challenge #2:  Tax withholdings only address one side of the equation.

When you look at the tax liability equation, there are many calculations that go into figuring out your tax bill.  Withholding from your employee wages is just one part of this.  Depending on what’s going on in your life, there are:

  • Income from other sources
  • Adjustments to calculate Adjusted Gross Income (AGI)
  • Adjustments to AGI
  • Deductions
  • Exemptions

However, focusing on tax withholdings doesn’t take any of these variables into consideration.  Practically speaking, it would be very impractical to expect an employer or the IRS to anticipate this in advance.  The IRS’ guidance to employers is to withhold taxes from income.  The taxpayer is responsible for resolving any discrepancies through their tax return.

Challenge #3:  Focusing on trying to ‘stop this interest-free loan' only increases frustration.

As you transition, expecting to get your withholdings exactly correct might frustrate you.  If you get it wrong, you might end up paying more money during tax season (especially if you were expecting to receive a modest refund).

Instead of trying to find more ways to decrease your withholdings, you might be better served looking for tax planning opportunities throughout the year.  While finding ways to decrease your tax bill will result in a larger ‘interest-free loan,’ the alternative is to simply let Uncle Sam keep the money.  Sitting down with a tax-focused financial planner is one of the best ways to discover tax planning opportunities.

Instead, you may want to wait until a year or two after you've made your transition.  This way, your financial life will be more stable.  You can also make minor changes to your W-4 to dial in the exact amount of tax withholdings based upon your new situation.

Situations in Which You WANT To Err on the Side of Caution

While many people worry about that ‘interest-free loan,’ the truth is that the converse is actually a worse situation to be in.  If you do not pay enough estimated taxes throughout the year, the IRS can impose penalties and charge interest for the unpaid estimated taxes.  IRS Publication 505 prescribes guidance on estimated taxes.  Under Pub 505, the IRS does not impose penalties if the taxpayer falls under one of the following situations:

  • Withholdings and current estimated taxes will allow the taxpayer to owe less than $1,000 upon filing their tax return
  • Current withholdings equal 90% of the current tax bill
  • Current withholdings equal 100% of the previous year’s tax bill

Since most people usually meet one of these criteria, they don’t normally have to worry much about withholding estimated taxes.  Even if there’s a huge event in one year, Pub 505 doesn’t mandate estimated tax payment if your withholdings equal last year’s tax bill.  Since one-time events are expected to normalizes the following year, these events usually don’t trigger estimated taxes.

However, if there is an expectation of significant taxable events occurring over more than one year, then estimated taxes may apply.  Below are a couple of examples of such events:

Starting a business as you transition

I love to hear stories of people who build their own business as part of their transition from the military. Many people have the enviable problem of having such a successful business that their military job actually holds them back.  In this situation, their business takes off exponentially once they can focus on it full time.  While this is great for the business owner, it’s easy to become complacent about tax responsibility.  If the business is profitable, and that profit becomes a substantial part of total income, then there may be a requirement to pay estimated taxes.  Failure to do so could eventually lead to a situation in which the taxpayer is non-compliant.

Capital gains over several years

Tax planning often involves a systematic approach to liquidating assets. For example, instead of selling a large chunk of securities in one year, it might be prudent to do so over a multi-year period in order to remain in a lower tax bracket.  However, if your plan involves a significant amount of sales, you may want to pay attention to whether you need to pay estimated tax.  Here are a couple of other examples of capital gains situations that may warrant estimated taxes if done over a multiple-year period:

Roth conversions

When you convert a retirement account to a Roth account, you are paying current year taxes in exchange for being able to have tax-free distributions in the future. Unless you contributed to a non-deductible IRA (for people who don’t qualify for a deductible IRA), this involves calculating and paying the tax bill for the amount of the conversion.  Staggering large conversion amounts over multiple years can be part of a wise tax planning strategy.  However, paying estimated taxes may be a prudent part of your Roth conversion strategy.

Post-military career

Many people find that their first year (or two years) of post-military life can be pretty bumpy. A significant part of this rocky transition is due to the uncertainty regarding the balance between pension & a post-military career.  In these cases, two different employers are now withholding (DoD and the new employer).  However, each employer only withholds according to the payroll information they have access to.  In fact, each employer may be underwithholding because the combined income now raises the taxpayer into a higher tax bracket.  Many people are disappointed to find that they now owe taxes upon filing their return.  However, it could be counterproductive to take actions that would make this problem worse.


No one wants to let the government hold on to their money any longer than absolutely necessary.  However, it’s important to note:

  • There’s much more value in tax planning than in trying to reduce your withholdings
  • As you transition to a post-military career, there may be situations in which a focus towards minimizing withholdings could be counterproductive to tax planning goals

If nothing else, tax season should drive home the importance of prudent tax planning.  If you’re interested in learning more about how tax planning can help your overall personal financial situation, you should talk with a tax-focused financial planner or tax professional.

Forrest Baumhover is a Certified Financial Planner™ and owner of Westchase Financial Planning, a fee-only financial planning firm in Tampa, FL. As a retired naval officer, Forrest helps veterans, transitioning servicemembers and their families address the financial challenges of post-military life so they can achieve financial independence and spend more time doing the things they love.

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