Understanding Tax Refunds: Why Less is More and How to Avoid Owing

Many taxpayers celebrate receiving a large tax refund, viewing it as a financial windfall or a forced savings plan. But the truth is, a big tax refund simply means you’ve overpaid your taxes throughout the year. In essence, you’ve given the government an interest-free loan of your hard-earned money.

Wouldn’t it be better to keep more of your money each paycheck, rather than waiting for a lump sum once a year? Understanding tax refunds and why getting a smaller refund—or even owing a small amount—can be more financially beneficial is the first step toward smarter tax planning.

Why Large Tax Refunds Aren’t Ideal

A sizable tax refund indicates that excess money was withheld from your paycheck throughout the year. While it might feel like a bonus, it actually represents missed opportunities for financial growth, such as:

• Investing: The money could have been invested, earning interest or dividends.
• Debt Reduction: Extra payments on credit cards or loans could save you from accruing high-interest debt.
• Budget Flexibility: Having access to more cash throughout the year provides better financial stability and flexibility.

By adjusting your tax withholding, you can better control your financial situation and optimize your earnings. Now, many people also think of it as a way for forced saving of money throughout the year or a way to pay off the debt they accumulated. If you want to have forced savings, it is better to have part of your paycheck go into a separate bank account each month and earn interest on those savings.

How to Calculate the Right Withholding Amount

Many people don’t realize that they can adjust their tax withholding to control the amount of tax taken out of their paychecks. Here’s how to get it right:

1. Review Your Current Withholding

   • Check your most recent paystub to see how much federal income tax is being withheld.
   • Compare it to last year’s tax return to see if you received a large refund or owed taxes.

2. Estimate Your Tax Liability

   • Use the IRS Tax Withholding Estimator to calculate your expected tax obligation based on your income, deductions, and credits. This tool helps you understand how much you should withhold to avoid both overpaying and underpaying.

3. Submit a New Form W-4

   • Adjust your withholding by completing a new Form W-4 and submitting it to your employer. The form allows you to fine-tune your withholding to better match your tax liability.
   • Consider updating your W-4 after significant life changes like marriage, the birth of a child, or a new job.

Tip: Revisit your withholding at least once a year or after any major financial changes.

When Should You Adjust Your Withholding?

Life changes can significantly impact your tax liability. Here’s when you should consider updating your withholding:

• Marriage or Divorce: Your filing status affects your tax bracket and liability.
• Birth or Adoption of a Child: You may qualify for additional tax credits or deductions.
• New Job or Income Change: Adjust for salary increases, bonuses, or a change in income source.
• Buying a Home: Mortgage interest and property tax deductions can lower your taxable income.

Regularly reviewing and updating your withholding ensures that you are neither giving the government an interest-free loan nor facing a hefty tax bill come April.

What to Do If You Owe Taxes This Year

First question is always determine the reason for the tax balance.  Addressing your tax balance and the reason for the balance, ensures that you will not owe next year.

Second, you should address the balances. Owing taxes can be stressful, but there are options to manage your tax debt:

• Pay What You Can: Even partial payments can reduce penalties and interest.
• Set Up a Payment Plan: The IRS offers installment agreements for those who can’t pay in full, including:
  • Short-Term Extension (up to 120 days): No setup fee, but interest and penalties apply.
  • Long-Term Payment Plans (Installment Agreements): Fees range from $31 to $225, depending on how you set up payments.
• Consider an Offer in Compromise (OIC): In cases of significant financial hardship, the IRS may agree to settle your tax debt for less than the full amount owed.

Note: At Ashley F. Morgan Law, PC, we specialize in helping clients negotiate tax debt resolutions, including installment agreements and OICs. Schedule a consultation to explore your options.

Common Penalties for Underpayment and How to Avoid Them

If you owe taxes, you might face penalties, including:

• Underpayment Penalty: Charged if you didn’t pay enough tax throughout the year.
• Failure-to-File Penalty: 5% of the unpaid taxes per month, up to 25%.
• Failure-to-Pay Penalty: 0.5% of the unpaid taxes per month, up to 25%.

How to Avoid These Penalties:

• Pay at least 90% of your current year’s tax liability or 100% of the previous year’s liability.
• Make Quarterly Estimated Payments if you have additional income not subject to withholding (e.g., self-employment income).
• Adjust your withholding on Form W-4 if you consistently owe taxes.

2025 Tax Updates: What You Need to Know

• The average tax refund for 2025 is approximately $2,100
• The IRS imposes penalties for underpayment of estimated taxes. To avoid these penalties, pay at least 90% of your current year’s tax liability, 100% of the previous year’s liability, or the total amount owed is less than $1,000.

Tax Refunds vs. Owing Taxes: Which is Better

While receiving a tax refund feels like a bonus, it’s merely a repayment of your overpayment throughout the year. Conversely, owing a small amount can indicate that you maximized your paycheck by not giving the government an interest-free loan.

While many people prefer receiving a tax refund, others find themselves owing money year after year. If you have regularly owed taxes in the past—especially if you’ve had trouble paying on time—a small or moderate refund may actually be the best strategy for you.

If you’re currently on an IRS payment plan or installment agreement, owing additional taxes at the end of the year could put your agreement at risk. The IRS expects taxpayers on payment plans to stay current with their taxes, meaning you must pay all future tax liabilities on time and in full. If you owe a balance when you file next year, the IRS could default your payment plan, leading to penalties, interest, or even collections actions such as levies or wage garnishments. A small refund ensures that you’re not adding new tax debt and helps keep any existing agreements in good standing.

Additionally, if you are actively paying down other debts, receiving a small refund can be a useful tool for financial stability. Instead of scrambling to pay a tax bill, you could use the refund to pay off credit cards, cover unexpected expenses, or reduce other financial burdens. This can prevent you from taking on new high-interest debt just to meet your tax obligations.

While breaking even is often ideal, if you’ve struggled with tax debt in the past, aiming for a small refund rather than a tax bill could be the best way to ensure you stay financially secure.

Understanding Tax Refunds vs. Tax Balances — Here’s the Bottom Line:

• Large Refund = Missed Opportunity (No interest earned on overpayment)
• Owing Small Amount = Better Cash Flow (You kept more of your money throughout the year)
• Small Refund = Financial Safety Net (No unexpected balance to pay for, helps cover tax obligations and keeps IRS payment plans in good standing)

The goal is to break even or get a small refund. This means you’ve optimized your withholding and maximized your paycheck. Ideally you would either owe or get back $100. But realistically, any refund under $1,000.00 is perfect.

FAQs About Tax Refunds and Owing Taxes

1. Why did I owe taxes this year when I usually get a refund?

You may have had less tax withheld from your paycheck, lost certain tax credits, or earned more income (like a side gig) without making estimated tax payments.

2. How can I adjust my withholding to avoid a big refund or a large tax bill?

Use the IRS Tax Withholding Estimator to determine the correct amount and submit a new Form W-4 to your employer with updated withholding instructions.

3. What happens if I can’t pay my tax bill in full?

The IRS offers payment plans, including short-term (120 days or less) and long-term (installment agreements). In some cases, you might qualify for an Offer in Compromise to settle for less than what you owe.

4. Are there penalties for underpaying taxes?

Yes. The underpayment penalty applies if you don’t pay enough throughout the year. The failure-to-file penalty (if you don’t file on time) and failure-to-pay penalty (if you don’t pay on time) can add up quickly.

5. What’s the difference between tax deductions and tax credits?

A deduction reduces your taxable income, while a credit directly reduces the tax you owe. For example, a $2,000 deduction lowers your taxable income, whereas a $2,000 credit reduces your tax bill by $2,000.

6. What are the most common tax credits I should check for?

Some key credits include:

• Child Tax Credit – Up to $2,000 per child, with up to $1,700 refundable.
• Earned Income Tax Credit (EITC) – For low- and moderate-income earners.
• American Opportunity Credit – Up to $2,500 for higher education expenses.
• Saver’s Credit – Up to $1,000 for retirement contributions.

7. How do I avoid owing taxes next year?

• Adjust your withholding by updating your Form W-4.
• Make quarterly estimated payments if you have self-employment or side income.
• Take advantage of tax credits and deductions.
• Stay on top of tax law changes that may affect your refund or liability.

8. Does Tax Debt Go Away with Bankruptcy?

Yes, but only in specific circumstances. Some tax debts can be discharged in bankruptcy, but there are strict rules. In general, for income tax debt to be discharged in a Chapter 7 bankruptcy, it must meet the following criteria:

• The tax return was due at least three years before filing bankruptcy.
• The tax return was filed at least two years before filing bankruptcy.
• The tax assessment (the IRS’s determination of what you owe) was made at least 240 days before filing.
• The tax debt is not due to fraud or willful evasion.

If your tax debt meets these conditions, it may be wiped out in bankruptcy. However, certain taxes, such as payroll taxes and recent tax liabilities, are not dischargeable.

For those who do not qualify for a full discharge, Chapter 13 bankruptcy can still help by restructuring tax debt into a more manageable repayment plan. Additionally, filing bankruptcy can stop IRS collection actions, including levies and garnishments.