Incoming Money From Taxes: What You Need to Know

Tax season doesn’t always mean paying the government—sometimes, it means receiving money instead. Whether through a refund, credit, or adjustment, tax-related funds can provide unexpected financial relief. Understanding how to use this money and its impact on overall finances is just as important as receiving it.

Before making any decisions, it helps to know why you’re receiving these funds, how they should be allocated, and whether they could impact future tax filings.

Why You Might Receive Funds

Receiving money from taxes typically happens when too much was paid throughout the year. One common reason is an overpayment due to payroll withholdings. Employers deduct federal and state income taxes from each paycheck based on Form W-4. If too much was withheld, the IRS or state tax agency issues a refund after processing the return.

Tax credits can also lead to refunds. Unlike deductions, which reduce taxable income, credits directly lower the amount of tax owed. Some, like the Earned Income Tax Credit (EITC) and the Child Tax Credit (CTC), are refundable, meaning they can generate a refund even if no taxes were owed. For example, in 2024, the maximum EITC for a family with three or more children is $7,430.

Self-employed individuals and freelancers who make quarterly estimated payments may also receive refunds if they overestimate their tax liability. If their income is lower than expected, they may have paid more than necessary, leading to a refund.

Allocation of Refund or Credit

Deciding how to use a tax refund can have a lasting impact on financial stability. While discretionary spending is tempting, strategic allocation provides long-term benefits. Paying down high-interest debt, such as credit cards or personal loans, can lead to significant interest savings. With average credit card interest rates exceeding 20% in 2024, reducing principal helps minimize future financial strain.

Another option is building emergency savings. Financial advisors recommend maintaining three to six months’ worth of essential expenses in a readily accessible account. A tax refund can help build or replenish this cushion, protecting against unexpected costs like medical bills or job loss. Nearly 60% of Americans cannot cover a $1,000 emergency without borrowing, making savings a practical choice.

Investing the funds is another way to improve financial security. Contributing to a Roth IRA, for instance, allows for tax-free growth and withdrawals in retirement. In 2024, the Roth IRA contribution limit is $7,000 ($8,000 for those 50 and older), and using refund money to maximize contributions can be beneficial.

For homeowners, applying the refund toward an extra mortgage payment can reduce total interest paid. Even one additional payment per year can shorten a mortgage term and save thousands in interest. Renters considering homeownership might allocate their refund toward a down payment, helping them meet lender requirements and reduce the need for private mortgage insurance (PMI).

Adjusting Future Withholdings

Receiving a sizable tax refund often means too much was withheld from paychecks throughout the year. While some prefer this forced savings approach, others may want to adjust withholdings to increase take-home pay. The IRS allows taxpayers to modify their withholdings by submitting an updated Form W-4 to their employer.

Fine-tuning withholdings requires assessing expected income, deductions, and credits for the year ahead. The IRS provides a Tax Withholding Estimator tool to help individuals calculate the appropriate amount to withhold. Those who consistently receive large refunds may benefit from reducing withholdings, allowing for more immediate financial flexibility rather than waiting for a lump sum. However, under-withholding can lead to a tax bill and potential penalties, particularly for those with multiple income sources or significant untaxed earnings, such as investment income.

Taxpayers with fluctuating earnings, such as gig workers or seasonal employees, should review their withholdings periodically. Unlike salaried employees with consistent paychecks, those with variable income may need adjustments throughout the year. If they experience a mid-year income increase, such as a raise or additional freelance work, they could be pushed into a higher tax bracket. The IRS generally requires taxpayers to pay at least 90% of their total tax liability throughout the year to avoid underpayment penalties, making proactive adjustments important for those with irregular earnings.

Taxable or Nontaxable Classification

Whether tax-related funds must be reported as income depends on their source and applicable tax laws. Most standard refunds from overpaid income taxes are not taxable at the federal level. However, exceptions exist when deductions or credits were claimed in prior years. If a taxpayer itemized deductions and deducted state income taxes paid, receiving a state tax refund the following year could create a tax liability under the IRS “tax benefit rule.” This rule applies when a deduction in a prior year provided a financial advantage, making the subsequent refund partially or fully taxable.

Certain refundable credits also have unique tax implications. While federal credits like the Earned Income Tax Credit (EITC) and Additional Child Tax Credit (ACTC) are tax-free, credits related to business activities may be treated differently. The Employee Retention Credit (ERC), for example, must be accounted for by reducing deductible wages in the year the credit applies, rather than being treated as nontaxable income. Similarly, excess premium tax credits from Affordable Care Act (ACA) marketplace plans may need repayment if income exceeds initial estimates, affecting tax liability rather than providing a straightforward refund.

Documenting the Amount in Your Records

Keeping accurate records of tax-related funds is important for financial planning and compliance. Proper documentation ensures refunds, credits, or adjustments are correctly accounted for in case of future audits or discrepancies. The IRS recommends retaining tax records for at least three years, though certain situations, such as unreported income exceeding 25% of total gross income, may require keeping records for up to six years.

Organizing records should include copies of tax returns, IRS notices, and bank statements reflecting direct deposit transactions. If a refund is applied toward future taxes instead of being issued as a payment, taxpayers should note this in their records to prevent confusion when filing the next year’s return. For businesses, refunds or credits related to payroll taxes, such as the Credit for Sick and Family Leave Wages, should be documented separately to ensure proper reconciliation with financial statements. Digital record-keeping tools, such as tax software or cloud storage, can help streamline this process and provide easy access if needed for verification.