Are Tax Returns Taxable? When a Tax Refund Is Income
Understand if your tax refund counts as income. This guide clarifies when refunds are taxable and how to properly report them.
Taxpayers often wonder if a tax refund, which is money returned to them by a government tax authority, is considered taxable income. This question arises frequently because many people assume that any money received is automatically subject to taxation. Understanding the nuances of tax refunds and their taxability is important for accurate financial planning and tax compliance.
Understanding Federal Tax Refunds
A federal income tax refund is generally not considered taxable income. This is because it represents an overpayment of taxes already paid on income previously earned and taxed. It is a return of your own money, not new income. A federal refund signifies you paid more in taxes through withholding or estimated payments than your actual tax liability.
However, any interest paid by the IRS on a delayed federal tax refund is taxable and must be reported as income.
Taxability of State and Local Refunds
State and local income tax refunds can be taxable, distinguishing them from federal refunds. This taxability depends on whether you itemized deductions on your federal tax return in the year the state or local taxes were paid and if those deductions provided a tax benefit. The “tax benefit rule” states that if a deduction reduced your federal taxable income in a prior year, then a subsequent refund of those taxes may be taxable.
For example, if you itemized deductions and claimed state and local income taxes on Schedule A of Form 1040, a later refund might be taxable. The taxable portion is typically limited to the tax benefit received from the original deduction. Conversely, if you took the standard deduction in the prior year, your state or local income tax refund is generally not taxable, as you received no federal tax benefit. States issue Form 1099-G to report these refunds, showing the amount in Box 2.
Reporting Taxable Refunds
If you receive a taxable state or local income tax refund, report it on your federal income tax return for the year received. This amount is entered on Schedule 1 (Form 1040), Line 1.
Only include the portion of the refund taxable under the tax benefit rule. The IRS provides guidance, such as Publication 525, to help determine the exact taxable amount. Even if the refund was credited to estimated tax payments or offset against other debts, it is still considered received and potentially taxable if you deducted the original taxes.