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While Americans may be divided when it comes to other tax-related topics, like how the government spends the money they pay in taxes, one thing unites us when tax season comes around: the desire to pay no cent more than we owe. So, when you receive a tax refund from the IRS, you may be wondering whether you’ll need to pay taxes on that amount and whether it’ll affect your state tax return and vice versa. Is a federal tax refund taxable?
A federal tax refund isn’t taxable, both at state or federal government levels. But if your federal tax refund came with interest, you’ll need to report the interest as income when filing your return because it’s taxable.
Read on for an in-depth discussion of what federal tax refunds are, how they may be affected by state tax refunds, and how you can increase your federal tax refund.
Understanding Federal Tax Refunds
In general, a tax refund refers to a type of reimbursement made to a taxpayer for excess money paid to the government from a prior year. If the refund comes from the federal government, it’s referred to as a federal tax refund. If it’s from your state, it’s a state tax refund. You receive federal tax refunds from filling out an income tax return.
More often than not, taxpayers view tax refunds as lucky windfalls. However, in most cases, a tax refund represents an interest-free loan made to the state/federal government.
Tax refunds may be issued in:
- Direct deposits to your bank account depending on direct deposit times
- Personal checks
- U.S. Savings Bonds
Are Federal Tax Refunds Taxable?
This question has two parts because the various states and the federal government recognize tax refunds differently when it comes to taxation. The first part of the question is, will the state tax a federal tax refund? In other words, do you need to report your federal tax refund as income in your state tax return?
The other part of the question is whether a federal tax refund is considered taxable income by the federal government. For example, whether you must report the prior year’s IRS refund as income in your current year’s federal tax return. Normally, hiring an accountant knows the answer to these questions.
Let’s address each question separately.
- The federal government does not tax federal income tax refunds. As such, you don’t need to report last year’s federal tax refund as income when filing the current year’s federal return with the IRS. However, suppose you received interest on the refund. In that case, you’ll need to report that, and it must be included in your tax returns because interest accrued from both the state and federal governments is taxable income.
Many people saw interest compensation reported during the 2020 tax year due to COVID and return processing delays from the government.
- Typically you will receive a 1099 G if any part of your refund is taxable.
Whether a federal tax refund is taxable at the state level, the answer is no, even though each state income taxes have different tax laws, forms, rates, and procedures. If you’re unsure whether you need to report federal tax refunds as income when filing your state tax returns, consult with a tax advisor in your state.
Federal vs. State Tax Refunds: Is There an Overlap?
Since you pay both types of tax and may qualify for refunds from either the state or the federal government, let’s find out if there’s a relationship between state and federal tax refunds. If any, we can then use it to determine what it means for you as the taxpayer when filing tax returns for both governance levels.
The most significant relationship between state and federal taxes (and any resultant refunds) is that a state tax refund might need to be reported as income in your federal tax return. If you include your state tax refund as income in your federal tax return, that’s going to increase your taxable income, which will subsequently affect the size of tax refund you get from the IRS.
Whether you need to report a state tax refund as income when filing your federal tax return will depend on whether you itemize your deductions on Schedule A (Form 1040) in the tax that gave rise to the refund.
If you receive form 1099, you must report that as income on your return. Additionally, you are more likely to itemize your return so you can deduct related personal expenses you paid for relating to your work.
If you didn’t take an itemized deduction, then you don’t need to report the tax refund as income when filing your federal tax return for the tax year that gave rise to the refund.
You may also be exempt from reporting state tax refund as income if you itemized but didn’t opt for an itemized deduction when filing state and local income taxes. This is often the case for some taxpayers who opt for a deduction on sales taxes at state and local government levels rather than income taxes. Taxpayers always have the option to deduct either of these two types of taxes, but never both.
If you itemized your deduction or claimed a deduction on income taxes (both state and local) in the previous year for taxes that gave rise to the refund, you may have to report the entire refund or a portion of it as income when filing your tax return. To determine the correct taxable portion of your state refund, consult Worksheet 2, Recoveries of Itemized Deductions in Publication 525, Taxable and Nontaxable Income.
Now, we’ve mentioned itemizing a lot, and not everyone is familiar with the term. To clarify things, let’s define it and establish a way to know if you itemized.
What Is an Itemized Deduction?
For tax purposes, itemized deductions refer to expenses that you can legally subtract from your Adjusted Gross Income (AGI) to lower your taxable income and, subsequently, your tax burden. This type of deduction must appear on Schedule A of Form 1040. In most cases, you’ll have the option to itemize or claim the current year’s standard deduction applicable to your filing status.
How Do You Know if You Itemized?
To find out whether you itemized, look for a Schedule A form in your return. If you can find it, you itemized your deductions because Schedule A forms are typically used to compute itemized deductions. If you can’t find the form, it means you opted for the standard deduction, eliminating the need to file a Schedule A.
Another way to determine whether you itemized is to access line 9 on your form 1040 and compare the figure in this space to the standard deduction amount that applies to you.
For illustration, let’s assume you filed your return in 2019. If you notice $12,200, $24,400, or $18,350, you likely didn’t itemize in line 9 of your Form 1040 because these figures represent the standard deduction amounts for single people, married couples filing jointly, and also heads of households respectively for that year.
Ways To Increase Your Federal Income Tax Refund
Having discovered that federal tax refunds aren’t taxable and that state tax refunds may be taxable, you may be contemplating how you can quickly increase your figure for the former. If so, here are two ways to do that:
Reassess Your Filing Status
Your filing status significantly affects your refund size, more so if you’re married. While filing jointly like most couples allows you to enjoy certain deductions, filing separately when you’re married can sometimes increase your refund. For instance, filing separately may mean a larger deduction if you or your significant other has sizable medical expenses (like COBRA payments arising from job loss).
If you’re unmarried, you can also cut your tax bills and increase your chances of a refund by changing your filing status to Head of the Household as long as you meet the requirements. Typically, taxpayers with this status enjoy more favorable tax brackets and a higher standard deduction than those filing as Single.
Most people don’t know this knowledge, but you can almost certainly qualify to file as the Head of Household if you cater for more than half of your parents’ financial needs (it doesn’t matter if they live in your house with you or not). The same can be said for those who’ve lived with a child for more than six months, during which you were financially responsible for them.
The magazines Kiplinger’s Personal Finance vs. Money Magazine have a lot of tips on taxes, itemizations, and tax refunds.
Leverage Tax Deductions
Most people know that tax deductions help lower their tax burden and increase the tax refund. However, keeping track of the available deductions eludes most people, leaving some eligible deductions unclaimed.
Here are some of the deductions you’ll want to be aware of:
- State sales tax
- Reinvested dividends
- Out-of-pocket charitable contributions
- Student loan interest
- Child and dependent care
- Earned income tax credit
- State income tax you paid on the previous year’s return
- Medical miles
- Some jury duty fees
- Charity miles
Note that all these deductions are subject to terms and conditions, so you’ll want to look into each separately to determine what you can deduct. Be sure to see what do I need to file my taxes so you have appropriate documents.
A 1099 is often considered bad because it is a form used by employers and is issued in the event of payment. However, if you have income from other sources aside from a job (whether “good” or not), then you need to keep track of all your earnings on this tax form as well.
The difference between a W box and an S box is that the W is for withholding taxes, and S is for social security.
If you owe back taxes, then the IRS is legally obligated to withhold your refund. This is because they can’t issue a refund until the taxpayer is current on their obligations with the IRS.
If you are operating your business as a limited liability company, it is essential to file a return with the IRS to know that you exist. Otherwise, they will not be able to collect taxes from you or send any refunds back out.
Summing Up Taxable Income
Unless you are working an under the table job, most of the time you will be paying taxes. Regarding the main subject of discussion, we’ve established that federal tax refunds are not taxable. As for the relationship between federal and state taxes and resultant refunds, we’ve seen that the most critical link is that state tax refunds may sometimes need to be reported as income when filing your federal tax return.