What is a tax refund?

How is a tax refund explained? It is a repayment from the government of any excess tax paid throughout the year above what the taxpayer actually owes. Tax is calculated as a percentage of income and certain purchases over the course of a year. There are various reasons a taxpayer might end up paying more than they need to in a given year. Some taxpayers use their annual tax refund to finance investments in the financial markets.

Where have you heard of a tax refund?

Receiving a tax refund is highly anticipated among individual taxpayers and you will have heard talk of refund payments, particularly during tax filing season at the end of the financial year. If a government changes any of its tax rates, for example to stimulate the economy, taxpayers may be eligible to receive an additional tax refund and there will be coverage in the news of the change in policy.

If a publicly listed company receives a tax refund it will be included as income in its quarterly, interim or annual earnings reports.

What do you need to know about a tax refund?

Now that we defined a tax refund, let’s take a look at some of the real-life examples. A tax refund can be paid in several ways, including through direct bank account deposit, cheque or savings bond. Payment is usually made a few weeks after the taxpayer files an annual tax return form.

In the US, the average tax refund in the 2020 financial year was more than $3,000 and around three-quarters of Americans receive one, according to the Internal Revenue Service (IRS). In the UK, a taxpayer may receive a refund if they are taxed under an emergency code when starting a new job, or if they are self-employed and overpay because of a change in circumstances, among other reasons.

Some taxpayers view a tax refund as a savings strategy to set aside money and receive it back as a lump sum. As a tax refund is typically an extra payment outside the taxpayer’s usual monthly budget, investors often treat the money as a bonus and a source of extra funds for buying financial assets such as stocks and bonds.

Using the money from a tax refund allows investors to make additional purchases of securities without dipping into their current accounts for day-to-day spending or cash savings. Alternatively, the funds can be used to pay off debt, finance a retirement account or save for a specific goal like buying a car or house.

Rather than overpaying tax and waiting to receive a refund, some taxpayers calculate their finances to get as close to their actual tax obligation as possible so that they do not overpay.

You can learn more about taxation, as well as tax shelters, dividend tax, capital gains tax and other related terms in Capital.com’s extensive investor-focused glossary.