Did you get a big tax refund last year…or were you left wondering, Why is my federal refund so low? The average tax refund has been slightly around $3,000 in recent years. That’s a meaningful amount of money, and plenty of people rely on this annual income infusion. Those who miss out often are disappointed—but should they be? In truth, receiving a big tax refund is a mixed blessing, explains our Bottom Line tax expert Abby Eisenkraft, EA. Here’s why…
Receiving a large refund from the IRS is more psychologically satisfying than having to write a check to the IRS for taxes owed. But a hefty IRS refund doesn’t mean that you’re scoring a taxpayer victory against the system or that your tax preparer is a miracle worker—it means you paid too much in taxes over the course of the year.
How does a tax return work: Employees typically have taxes withheld from their paychecks throughout the year. Retirees usually have money withheld from their withdrawals from tax-deferred retirement plans, and some also have money withheld from their Social Security benefits and other sources. Those who are self-employed generally make quarterly estimated tax payments.
Receiving a big tax refund means that this withholding or those estimated tax payments were larger than they needed to be. In other words, a tax refund is not found money…it’s your money being returned to you—money that you could have had months earlier. The larger your refund is, the more you overpaid throughout the year.
Some tax preparers go so far as to compare receiving a big tax refund with making a loan to the US government—and not earning any interest payments for doing so. Perhaps you could have invested that money instead and ended up with a larger amount than you eventually received back from the IRS. That’s a particularly compelling argument during years like 2024 when the stock market does well.
Also, if your budget has been stretched thin, reducing the withholding or making smaller quarterly tax payments could have reduced the financial pressure you endured over the course of the year. Nearly 40% of people who receive tax refunds plan to use that money to pay down debt, according to a survey by financial company Lincoln Financial. Instead, you could have paid less in taxes during the year and used the extra money to pay down debt sooner or not go into debt at all. Avoiding debt or paying debt down as soon as possible can be a big money saver—the average interest rate imposed by credit cards currently is around 25%.
Giving the government an interest-free loan each year might not be the savviest money move on paper. But in practice, overpaying your withholding or quarterly tax payments, then receiving a big tax return may be an effective strategy for you since it creates enforced savings.
If you struggle to save and stick to a budget, you may use a big tax refund each year to pay for an annual vacation…or to make an annual contribution to an IRA…or start an emergency fund. If you paid less in taxes over the course of the year, you likely would spend more throughout the year and have nothing left over for these big annual expenses. If you’re reading this and thinking, There are better ways to save, you’re right. But if you’re someone who just can’t seem to save and budget, then letting the IRS hold onto some of your money each year might be more prudent than having access to that money yourself.
If you are employed, you can reduce the amount that your employer(s) withhold from your paychecks by filling out a new IRS Form W-4, Employee’s Withholding Certificate, and submitting this form to your employer’s human resources department. You can do this at any time during the year.
If you are retired, you often can reduce the amount that is withheld from withdrawals from your tax-deferred retirement plans by submitting a new Form W-4P, Withholding Certificate for Periodic Pension or Annuity Payments, to the plan administrator. But keep in mind that withholding rates are inflexible for certain types of retirement plan withdrawals. If you are having taxes withheld from your Social Security benefits, you can adjust that withholding by filing a new Form W4-V, Voluntary Withholding Request, with the Social Security Administration.
If you are self-employed, you can lower the amount you pay in estimated taxes simply by sending less to the IRS each quarter.
A few things to watch out for before you reduce the amount you pay in taxes over the course of the year …
If you pay too little to the IRS over the course of the year, you could end up owing an underpayment penalty. To avoid this penalty, your withholding and estimated quarterly payments generally cannot be less than 90% of the tax you owe for the year or less than 100% of the amount you owed the prior year, whichever is lower.
Slightly different rules apply if your adjusted gross income (AGI) for the prior year was greater than $150,000…or greater than $75,000 if married and filing separately. These high-earners must pay either 90% of the amount owed in the current year or 110% of the amount owed the prior year to avoid the underpayment penalty.
Helpful: Your tax preparer can help you select appropriate withholding levels or estimated tax payments and/or you can use the IRS online tax withholding estimator tool.
Be honest with yourself about your ability to save and budget responsibly. If having more money in your bank account throughout the year would likely result in that money being frittered away, then perhaps you’re better off paying too much in taxes all year and getting a big refund back.
Alternative: Making excessive tax payments all year isn’t the only way to enforce savings. You could instead pay less to the IRS over the course of the year but have automated contributions made from your bank account or paycheck to your retirement plan or another investment account.
If your income varies significantly from year to year, then getting your withholding and estimated taxes just right will be a challenge. It’s not unreasonable to conclude that it’s better to receive a big refund some years than have to write a big check to the IRS during tax season in other years.
