Every April, half of America gets a tax refund and feels great about it. The other half owes the IRS money and feels bad about it.
Both reactions are backward.
What a refund actually is
When your employer pays you, they withhold a chunk of your paycheck for the IRS based on a form you filled out (the W-4) when you got hired. They send that money to the IRS every two weeks, all year long.
At the end of the year, your real tax bill is calculated based on your actual income and deductions. If you withheld more than you owed, the IRS sends you a refund. If you withheld less, you owe.
A refund is not the government giving you money. It’s the government giving back the money it took from you that it never had a right to in the first place.
Concretely: the IRS held that money for an average of 6 months. If you had $3,000 sitting in a 4% savings account for 6 months instead, you’d have earned about $60. That’s the literal direct cost of overwithholding.
Why it feels like a windfall
Two reasons it feels good:
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Lump sum vs. trickle. A $3,000 refund hits your bank account on one Tuesday in April. The alternative — having $115 more in every biweekly paycheck — feels invisible because it’s diluted. Lump sums register psychologically; trickles don’t.
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Forced savings. A lot of people who get refunds say “I’d just spend it if it were in my paycheck.” This is a real behavior fact for some people, and worth being honest about.
If the second one applies to you, overwithholding is a working strategy, just an expensive one. You’re paying the IRS to be your savings account. The fee is ~$60-100/year per $3,000 of overwithholding. For some people, that fee is worth it. For others, it’s a reflex from when their parents told them refunds were good.
The right amount to withhold
The IRS-pleasing answer: enough to cover your actual tax bill. Refund of $0, owe $0.
The realistic answer: aim for a small refund (a few hundred dollars) as a buffer against year-end surprises (a Roth conversion you forgot, a stock that paid an unexpected dividend, etc.). A small refund protects you from owing the IRS — which, importantly, also avoids the underpayment penalty.
The underpayment penalty (the real reason you can’t just stop withholding)
If you owe more than $1,000 at filing time AND didn’t pay in at least 90% of what you owe through withholding (or 100% of last year’s tax, whichever is less), the IRS charges a penalty. The rate floats — usually 7-8% APR on the underpayment — and it’s the IRS’s polite way of saying “give us the money on schedule, not in April.”
So you can’t just zero out your withholding. The IRS structurally needs to be receiving the money throughout the year. The safe harbor: pay in (via withholding + estimated payments) at least 100% of last year’s total tax, or 110% if your AGI was over $150k.
How to actually adjust
The W-4 form has been simplified since 2020. Two main levers:
- Step 4(c) — “Extra withholding.” Add a dollar amount per pay period. Increases your withholding. Use this if you owe at filing.
- Step 3 — “Claim Dependents” and similar. Reduces your withholding. Use this if you over-withhold.
Practical approach: log into the IRS Tax Withholding Estimator (irs.gov/individuals/tax-withholding-estimator). It asks you about 10 questions and tells you exactly what to put on a new W-4 to land where you want. Submit the new W-4 to your employer. It takes effect within 1-2 paychecks.
Do this in February once you have last year’s tax return as a reference. Sets you up correctly for the year ahead.
The thing nobody says
For people who already save consistently, refunds are pure inefficiency. You’d be better off with the smaller refund (or owing a small amount) and putting the extra paycheck money into your high-yield savings or 401k automatically.
For people who don’t save consistently, refunds are a forced-savings hack that works. The cost is real but small. The benefit (actually accumulating savings instead of spending paycheck to paycheck) can be much larger.
Don’t let anyone, including this article, shame you into “fixing” your refund situation if forced savings is what’s making your overall financial picture work. The right move is to be honest about which person you are.