What Is a Tax Refund?

What Is a Tax Refund? article image.

There's exactly one good reason to look forward to tax season: You may be entitled to a tax refund. Simply put, a tax refund is the difference between what you've paid to the government in withholding or estimated taxes and the amount of taxes you owe. If what you paid more in taxes was more than what you actually owed the government, you will receive a tax refund.

Before you start celebrating, though, here's a quick look at how to calculate your refund, how you might receive and track it, and what you might want to do with it once it's yours.

How Do Tax Refunds Work?

While there's only one federal tax deadline date, most of us accrue and pay taxes throughout the year. As you earn income, that income incurs tax liability. Typically, you also pay taxes—either in the form of withholding (money taken out of your paycheck or other payments) or estimates (tax payments you send to the government)—as you receive income.

Your tax return reconciles these four things:

  1. Income: The amount of money you earned in wages, business income, investment gains, unemployment benefits and so on.
  2. Taxes: What you owe the federal and—in some cases—state or local government based on your total income, minus any deductions or allowances that may apply.
  3. Payments: Any money you've paid to the government toward your taxes.
  4. Credits: Money you may deduct directly from your tax bill. Examples include:
    • Earned income tax credit, which provides relief to low-income taxpayers and their families. The IRS has a tool to help you figure out if you qualify. For the 2020 tax year only, you may use either your 2020 or 2019 income to qualify.
    • Child tax credit, which offers $2,000 per qualified dependent in income tax credits for taxpayers who meet IRS income guidelines.
    • COVID-19 stimulus payments, which are also technically tax credits. Most eligible taxpayers have already received their COVID-19 credits in the form of stimulus payments, but if you haven't—and you qualify—you can use the Recovery Rebate Credit to apply stimulus payments to reduce your tax bill or increase your refund.

Your completed tax return should tell you whether you owe the government additional money, paid the correct amount already or can expect a tax refund.

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How to Claim Your Tax Refund

Are you due a refund? Here are three common ways to claim it.

  • Request direct deposit. The IRS can deposit your refund electronically into your bank account if you request this option on your tax return. Direct deposit allows you to avoid mail delays and is the fastest way to receive your refund, according to the IRS.
  • Receive a check in the mail. You can request a paper check instead of direct deposit, but expect to wait—even more so if you're mailing in a paper tax return. The IRS anticipates significant delay in both mailing times and the processing of paper returns this year.
  • Apply it to your next year's tax bill. If, for example, you are self-employed and pay quarterly tax estimates, your first 2021 estimate is due on May 17, 2021 (the extended IRS deadline resulting from ongoing challenges of the coronavirus pandemic). Rather than wait for a payment from the government only to pay it right back to the Treasury, you can apply your refund to your next year's taxes and call it a wash.

If your refund isn't as robust as you might have hoped, consider working with a tax advisor to maximize your deductions and minimize your tax liability going forward. Although you probably won't be able to reduce your tax burden to zero, you may find ways to bring your overall tax bill down. Consider this as well: A large tax refund may be a sign that you're giving too much money to the government throughout the year. You may want to adjust your withholding or estimated tax payments and keep more of your money as you go.

Where Is My Tax Refund?

The IRS says it issues nine out of 10 refunds in fewer than 21 days. Of course, if your return is incomplete or incorrect, includes a claim for an Earned Income Tax Credit or Additional Child Tax Credit, or you've been a victim of identity theft, your refund may take longer to process. You'll also wait longer if you file your taxes or receive your refund by mail.

You can track your refund payment using the IRS' Where's My Refund? tool or by downloading the IRS2Go mobile app. Using these tools won't expedite your refund, but they will allow you to see its progress. Many states also have online or mobile tracking for tax refunds: Search your state and "tax refund tracking" to find out more.

How to Use Your Tax Refund Money

A tax refund is 100% your money and you are free to use it in any way you choose. That said, you may want to be intentional about using your tax refund money. It's your chance to pay down debt, launch an emergency fund, save for your retirement or even invest in yourself. If the past year has brought financial challenges your way, the lump sum you receive as a tax refund can help you recover.

If you just can't wait to receive your tax refund, some tax preparation services and tax preparation software companies may allow you to borrow against it with little or no interest and fees. You may not be able to borrow the entire amount you expect to be refunded—and you should always read the fine print—but this may be a viable option if you need the money as soon as possible.

Getting a tax refund is certainly something to look forward to, even if preparing your taxes and waiting for your money can seem a little bit like work. And if you've survived the sometimes confusing financial year that was 2020 without owing additional money to the government, you deserve extra kudos.