Here’s When Small Tax Refunds Are Actually a Good Thing

Filing taxes is one of Americans’ most dreaded annual chores, and this year, it may be even more dreadful for the many taxpayers who find their tax refund has shrunk.

In case you haven’t already heard: Your refund is likely to be smaller in 2023 than the past couple years due to several expiring pandemic-era measures that had temporarily juiced the amount that the IRS was paying out to tens of millions of Americans.

So far this year, IRS data shows the average tax refund is 11% less than what it was at this point last year. When unexpected, a smaller tax refund can be a real financial bummer, especially if you’re among the third of Americans who rely on their tax refunds to make ends meet.

And yet, perhaps surprisingly, many folks actually want a lower tax refund — or no refund whatsoever. Advice from financial experts backs up what may sound counterintuitive: Smaller is usually better. Instead of a joyous windfall from Uncle Sam, a tax refund, they say, represents an interest-free loan that you’ve given the federal government.

“For the most part,” says Erica York, a senior economist at the nonprofit Tax Foundation, “a refund means you had too much taxes withheld from your paycheck. You overpaid to the federal government throughout the year, and you’re getting back what you could have had all along.”

That doesn’t necessarily mean tax refunds are a bad thing, though. Many people get tax refunds due to refundable tax credits such as the earned income tax credit and the child tax credit. These types of credits lower your tax liability, and if what you owe in taxes is less than the value of the credit, then you get that money back, thereby boosting your refund amount.

Refundable tax credits aside, the size of your tax refund is based on how much federal taxes are taken out of your paycheck — and that’s something you do have control over.

What’s the ideal tax refund size?

It’s simple to say that most of us should be aiming for a smaller refund, but it’s much trickier to define what that means exactly. With the current average tax refund sitting at about $3,000 so far this year, what would qualify as the ideal refund size?

In a perfect world, you’d always stay within your budget, you’d never splurge on expensive coffees, you’d save at least 15% of your income for retirement — and your tax refund (and tax bill) would be $0.

But we’re not perfect, and sometimes we can get hung up on all the financial optimizations, says Randall Watsek, a financial advisor at Raymond James.

“There’s a difference between what might be theoretically, financially optimal and what might be better in a practical sense,” Watsek says.

For instance, if your tax refund was perfectly optimized to $0, you would have more money in each paycheck than if you were receiving a refund. Each pay period, you could put that money to use — and even earn interest on it throughout the year by putting it into a high-yield savings account or money market account.

On the other hand, people who receive over-sized tax refunds are missing out on that theoretical interest, says Kendall Meade, a certified financial planner at the online lending and personal finance company SoFi. However, she notes the $0-refund strategy doesn’t take into account our behavioral side.

“Keep in mind your own relationship with money and how likely you may be to spend the money,” Meade said in an email.

In the case that your paychecks are bigger, but you’re unlikely to have the self discipline to save that additional money each pay period, switching to a tiny tax refund might not be the best idea. Sometimes, Watsek says, a tax refund is easier to put in a “separate mental bucket,” as in: Hey, I just got a big check from the IRS, maybe I should pay down some high-interest debt or contribute to an IRA.

Of course, the opposite can also be true: A large windfall from a tax refund might tempt you to blow it all on a shopping spree. If that sounds like something you’d do, perhaps aiming for the smallest refund possible is the right course of action.

“I like the idea of a little wiggle room, maybe aiming for $500 so you don’t end up with an accidental surprise tax bill,” says York.

Instead of $0, York’s example of a modest refund around $500 is a classic case of loss aversion.

“It feels worse to have to pay the IRS than have the IRS pay me,” she says.

Ultimately, your personal situation and your spending behaviors are what’s important. York says the $500 example isn’t meant to be a blanket recommendation. Instead, the smallest tax refund that’s financially sustainable for your situation is what you should be aiming for.

How to fine-tune your tax refund

Now that you’ve defined your ideal payment from Uncle Sam, how do you actually go about fine-tuning the size of your tax refund? Unfortunately, that option is out of the question for your 2022 taxes (those are coming due in April). But you can make changes for next year’s refund.

First, start by using the IRS’s tax withholding estimator. This tool allows you to estimate the federal payroll tax that is withheld from each paycheck and thus see the size of your refund. It also has a handy slider bar that allows you to essentially choose the size of your tax refund.

To make sure you don’t accidentally miscalculate your withholding and end up owing the IRS, be as thorough as possible when using the tool. You’ll want to reference your most recent paystub(s) and any other form of income, including government benefits and investments. As the IRS warns, the “results are as accurate as the information you enter.”

To get the tax refund size you want, you’ll also need to update some paperwork with your employer. You must use the W-4 tax form from the IRS and input the new tax withholding amount based on the results from the IRS’s calculator, then file that form with your employer. Once your form is processed with your employer, double-check future paychecks to ensure the changes went through.

Aside from picking the perfect refund size, York says you should also update your withholding with your employer after major life events, such as earning a raise, having a kid or getting married — because those events will also change your tax situation.

“Update your withholding so it reflects what’s going on in your life rather than just setting it and forgetting it for years,” she says.

Because you should never wait until the day before Tax Day

April 18, 2023

File your state and federal taxes with the help of a Tax Preparation Software by clicking above.

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More from Money:

When Are Taxes Due in 2023? Here Are the Deadlines You Need to Know

How to File Your Taxes for Free in 2023

Here’s How to Track Your Tax Refund

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