Is It Good to Owe Taxes or Get a Refund?

Taxes are mandatory financial contributions collected by governments to fund public services. For many, the annual tax filing process raises a common question: Is it financially beneficial to receive a tax refund or to owe a small amount? This confusion often stems from a misunderstanding of how tax withholding works, with the “goodness” of either scenario depending heavily on an individual’s financial strategy and goals.

Understanding Your Tax Liability

Your total tax liability is the actual amount of tax you are legally obligated to pay to the government based on your income, deductions, and credits for a given tax year. This liability is determined by specific tax laws and is independent of how much tax has been withheld or paid throughout the year. Tax withholding refers to the money an employer deducts from an employee’s paycheck and remits to the government. For individuals with income not subject to withholding, such as self-employment earnings, estimated tax payments are made directly to the government periodically.

A tax refund occurs when the total amount of taxes withheld or paid through estimated taxes exceeds your actual total tax liability for the year. Conversely, owing taxes at the end of the tax year means the amount withheld or paid was less than your total tax liability. Your true tax obligation is established by your gross income, deductions, and credits, not by whether you receive a refund or make an additional payment when filing.

The Goal of Tax Withholding

From a personal finance perspective, the most efficient outcome at tax time is to have paid just enough through withholding or estimated payments to cover your total tax liability. This results in a minimal amount owed or a small refund.

A large tax refund, while often seen as a bonus, signifies you have provided an interest-free loan to the government. The money tied up in an excessive refund could have been earning interest in a savings account, invested in a retirement fund, or used to pay down high-interest debt. By having access to more of your income throughout the year, you retain control over your funds. This allows for proactive financial management, such as contributing to an emergency fund or making additional principal payments on loans.

Consequences of Under or Over Withholding

If you underpay your taxes throughout the year, you may face penalties for underpayment of estimated tax. The Internal Revenue Service (IRS) generally requires taxpayers to pay at least 90% of their current year’s tax liability or 100% of their prior year’s tax liability through withholding or estimated payments to avoid such penalties. For higher-income taxpayers with an adjusted gross income of more than $150,000 in the prior year, the safe harbor rule requires paying 110% of their prior year’s tax liability.

On the other hand, consistent over-withholding, which leads to large refunds, also carries its own set of financial drawbacks. While not a penalty in the traditional sense, it signifies missed investment opportunities or challenges in managing personal cash flow throughout the year. The funds that could have been working for you, either through investments or by reducing debt, were instead held by the government without earning any return.

Strategies for Optimal Tax Withholding

To align your tax withholding with your actual tax liability, employees should regularly review and update their Form W-4 with their employer. This form allows you to adjust the amount of federal income tax withheld from each paycheck. Factors to consider when completing or updating your W-4 include changes in dependents, significant changes in income, having multiple jobs, or receiving substantial non-wage income such as investment dividends or interest. Accounting for itemized deductions or tax credits you anticipate claiming can also help refine your withholding.

Individuals who are self-employed or have other significant income not subject to withholding are generally required to make estimated tax payments throughout the year. These payments, typically made quarterly using Form 1040-ES, ensure that you meet your tax obligations as income is earned. The due dates for these quarterly payments are generally April 15, June 15, September 15, and January 15 of the following year. Utilizing the IRS Tax Withholding Estimator, an online tool, can provide personalized guidance to help determine the appropriate withholding amount for your specific financial situation.

It is advisable to review your tax withholding settings annually or whenever a significant life event occurs, such as marriage, divorce, the birth of a child, or a change in employment. Proactively managing your withholding helps ensure you neither underpay and incur penalties nor overpay and miss out on the immediate use of your funds. Adjusting your withholding can help you achieve a financial equilibrium at tax time, keeping more of your money available for your personal financial goals throughout the year.

Citations

Tax Topic 306, Penalty for Underpayment of Estimated Tax. Internal Revenue Service.
Tax Withholding Estimator. Internal Revenue Service.