Receiving a large tax refund feels like getting a bonus or award. After all, it is the one time the government sends you a nice big check.
The average American who received a refund in 2016 got a hefty $2,860, according to the IRS. And while most people plan to do smart things with that windfall, such as shoring up savings or paying off debt, the question recipients should be considering is not what to spend that money on but rather why they got it in the first place.
A tax refund is simply the difference between the taxes you paid the government and the taxes you owe. Receiving a large refund means you've overpaid relative to the total tax obligation that you will tote up at tax time.
"It means we made a mistake and are having too much withheld from us each paycheck," says Kansas City, Mo., financial planner Tyler Landes.
Ideally, you should aim to have no refund at all because then you've paid the correct amount of taxes and have not "made an interest-free loan to the government," says CPA Melissa Labant, director of tax advocacy for the American Institute of CPAs.
Why You Want a $0 Refund
A big tax refund costs us not only the larger paychecks we could have been receiving throughout the year, but also the lost opportunity to use those funds. Rather than let the government hold those dollars, "you're better off earning a return on that money, whether it’s through investments for your future or by paying off debts," says Ashburn, Va., financial advisor Ted Halpern.
For example, if you receive a $3,600 tax refund this year, that's an additional $300 a month you went without in 2016. Let's say you have a $14,000 credit-card debt with an 18% interest rate. Applying that $3,600 to your debt as you earned it, rather than all at once the following spring, would have saved you about $300 in interest costs in just that single year, according to Bankrate's credit card calculator tool.
Or you could have applied those extra dollars from your pay to your 401(k), getting more dollars invested in a year when the S&P 500 stock index returned 12%.
Even turning those funds over to a bank account in this period of historically low interest rates would have reaped a better return than allowing the government to hold on to it. After all, even 0.06%, the current average savings account interest rate, according to the FDIC, is a better return than 0%.
If you had a rough year making ends meet due to a medical emergency or necessary home repair, think how helpful having access to those additional funds would have been.
How to Reduce Your Tax Refund
To avoid a big refund again this year, contact your employer or HR department and reduce your withholding amount, using IRS Form W-4. You can make adjustments throughout the year. You don't need to wait until the following year for your tax withholdings to reflect life changes such as purchasing a home or the birth of a child.
Getting your withholding right is tricky if you have complicated taxes, or if your income and expenses vary significantly from year to year. So even if you revisit your W-4, make sure you have dollars available at tax time in case the estimate falls a little short, says Landes. You can also consult with a CPA to run an income-tax projection if your situation is more complex.
You're not done once you adjust your withholding. To give your financial life a boost, you also need to be wise about what you do with the extra income that will be appearing in your paycheck. If you don't trust yourself to not blow it, increase what is set aside for your 401(k) or set up automatic withdrawals from your checking account into a savings account. You won't see this money in your spendable account—just like when it was going to the IRS—so you won't be tempted to spend it.
If overpaying the government feels like the only way you can ensure that you save, be sure to treat that tax refund as forced savings and send those dollars directly to your savings account so you don't end up spending them on daily expenses or a treat.