What Is a Tax Refund?

A tax refund is a reimbursement to a taxpayer of any excess amount paid to the federal government or a state government.

Taxpayers tend to look at a refund as a bonus or a stroke of luck, but it most often represents an interest-free loan that the taxpayer made to the government. In most cases, it is avoidable.

Key Takeaways

  • If you get a tax refund, it means you overpaid your taxes last year.
  • Regular employees can avoid them by accurately filling out Form W-4 and keeping it up to date.
  • Self-employed people can avoid it by estimating their taxes more accurately for quarterly estimated tax payments.

Understanding a Tax Refund

There are a number of reasons a taxpayer may get a refund of more than a trivial amount of money (or owe more than a trivial amount to the government):

The first two examples are easily avoided. That is, the money would have been paid to the taxpayer over the course of the year if the correct information had been on the W-4 form.

Of course, sometimes a tax refund is both unavoidable and welcome. For instance, a taxpayer who was laid off early in the year and was unable to get a new job immediately might receive a substantial refund based on his or her actual annual income.

Refundable Tax Credits

Most tax credits are non-refundable. That is, a taxpayer who owes nothing forfeits the remaining tax credit. But there are exceptions.

  • The taxpayer has made an error in filling out Internal Revenue Service (IRS) Form W-4, which is used to estimate the correct amount to be withheld for taxes from the employee's paycheck.
  • The taxpayer has forgotten to update this form to reflect a change of circumstances, such as the birth of a child and thus an additional Child Tax Credit.
  • The taxpayer purposefully fills out the Form W-4 in order to have a higher withholding and larger tax refund at tax time.
  • The taxpayer was eligible for refundable tax credits, which can reduce the amount of taxes owed below zero, even if no tax was otherwise owed. The amount in excess of tax due is returned in the form of cash. (Most tax credits are not refundable, which means the tax liability can only be reduced to zero with no refund in excess of taxes paid.)
  • A freelancer or self-employed person who has to file quarterly estimated taxes may overpay to avoid a surprise tax bill or underpayment penalties when they file their tax return.

Refundable tax credits include:

  • The child tax credit. For tax years 2020, this credit is a maximum of $2,000, with up to $1,400 refundable. For tax year 2021, the tax credit was raised to $3,000 for children ages six through 17, and $3,600 for children under age six as part of the American Rescue Plan. The credit is now fully refundable, rather than partially refundable, and there is no income limit for the credit.
  • The earned income tax credit (EITC). This is a payment to moderate- and low-income workers who earned an income through an employer or by working as a self-employed individual with a business or farm. They must meet certain criteria based on income and number of family members. The maximum EITC for qualifying taxpayers with 3 or more children is $6,660 in the 2020 tax year and $6,728 in the 2021 tax year.
  • The American opportunity tax credit (partially refundable). This is available to taxpayers to offset qualified higher education costs. If a taxpayer reduces their tax liability to $0 before using the entire portion of the $2,500 tax deduction, the remainder may be taken as a refundable credit up to the lesser of 40% of the remaining credit or $1,000.

Both the original $1,200 ($2,400 for couples and $500 per child) stimulus payment, officially known as a "Recovery Rebate," and the newer $600 payment ($1,200 for couples, $600 per child) are classified as advance refundable tax credits on 2020 taxes. This means no matter how much a taxpayer owes (or doesn't owe) in taxes for the 2020 tax year, that taxpayer will get to keep all the money. Additionally, no taxes will be due on the amount received.

How a Tax Refund Works

Tax refunds can be issued in the form of personal checks, U.S. savings bonds, or direct deposits to the taxpayer's bank account, among other options. Most are issued within a few weeks of the date the taxpayer initially files a return. However, there may be some instances where a refund takes longer.

If a taxpayer claims an earned income tax credit or additional child tax credit, the refund will not be issued prior to a specific date, regardless of when the tax return is filed. For 2020 taxes, the IRS is estimating the first week of March for taxpayers claiming these refundable tax credits, if no other issues arise with the tax return and direct deposit is selected as the refund delivery method.

A tax refund is repayment of an interest-free loan to the government, not a happy windfall. It can usually be avoided.

Refunds are always pleasant, but it would be better to avoid overpaying in the first place by claiming properly filling out your W-4 Form or more precisely calculating your estimated taxes. The closer you can get your refund to zero, the more money you will have throughout the prior year.

Not everyone agrees. Some people consider tax refunds an alternative savings plan and look forward to the lump-sum repayment.