Interest from the IRS – When a Tax Refund Becomes an Investment
Most people are familiar with interest only in the context of banking and loans. Generally speaking, interest is always paid when a sum of money owed is paid late. For example, after taking out a loan, a certain interest rate must be paid for the period until the loan is repaid. Similarly, interest is sometimes charged when a payment is made late. Most people tend to pay interest more often than they earn it. The exception is interest on accounts and savings accounts. With interest rates currently very low, interest income is not relevant at all for many people. But what if we told you that, as a taxpayer, you can benefit from interest income? As part of a tax refund, it is possible that the tax authorities may have to pay you interest. In this article, we’ve summarized exactly when this happens and how you, too, can benefit from it.
The Basis – Interest on a Tax Refund
Although many taxpayers feel that the tax authorities only come into play when demanding payments, tax refunds do indeed exist. If too much income tax was paid as part of advance tax payments, the taxpayer can reclaim this amount through their tax return.
Initially, the tax refund is interest-free. Only the difference is paid out. However, if a certain period elapses between the relevant tax year and the issuance of the tax assessment notice, interest becomes due. There is an interest-free period of 15 months following the end of the calendar year in which the original taxes were due. Once this period has expired, the tax office must pay interest in addition to the tax refund. As is customary with interest, a monthly interest rate applies. It is calculated at 0.5 percent per month. What may seem like a small amount over a short period can quickly add up. Compared to many conventional “investments,” 0.5 percent per month is actually quite respectable.
How can you benefit from tax interest?
Unless you file your tax return on time and there are no further issues with the tax office, you will not be able to benefit from the interest. Since this is exactly how things go for most taxpayers, it’s no wonder that very few are even aware of the potential interest. After filing your tax return, the tax assessment notice usually arrives in your mailbox within two to three months. This means the interest-free period is far from over. So, to receive interest in addition to your tax refund, one of the following three scenarios must occur:
- You have filed an appeal against the tax assessment.
- You challenge the tax office’s decision in court.
- A voluntary tax return is filed very late.
This makes it clear that interest primarily accrues when, as described in points 1 and 2, there is a problem or a dispute with the tax office. The refund is delayed in this context and may be prevented beyond the interest-free period. The only way to effectively trigger the payment of interest is by filing a voluntary tax return. Unless you are required to file a tax return, you can still submit it up to four years later. If the tax return is filed very late, this results in a significant period during which interest accrues.
Example – What might an interest payment from the tax office look like?
To illustrate the conditions mentioned above, we have provided an example below. We are referring to the third option mentioned earlier: a tax refund with interest.
We assume that you file a voluntary tax return for the 2016 tax year. You submit your tax return by the latest filing deadline, i.e., December 31, 2020. What will happen next? After the tax return has been processed, you may receive the corresponding tax assessment notice in March 2021. It will list a tax refund of 2,000 euros. In addition to the tax refund, interest will be paid. This is calculated as follows:
Since the 2016 tax year has ended, we must first add the 15 interest-free months. No interest is charged for this period. The first month in which interest accrues is therefore April 2018. Since the tax assessment notice is issued in March, all months up to February 2021 are considered to accrue interest. This results in 35 months of interest.
In addition to the tax refund, several hundred euros in interest will also be due. It should be noted that this example has maximized the interest period and used a comparatively high refund amount as a basis. Depending on the amount of the refund and the number of months subject to interest, the total may be lower, but of course it may also be higher.
Frequently Asked Questions About Interest Payments from the Tax Office
Now that it should be clear how interest is calculated on a tax refund, we would like to answer two frequently asked questions.
We are often asked whether interest must be applied for. The answer is no. You do not need to apply for the interest separately. If you are entitled to it, the tax authorities will calculate the respective interest and automatically transfer it along with the refund.
Is the interest taxable? At first, it sounds a bit absurd that you would have to pay taxes on interest from a tax refund. But in fact, this interest is also considered interest income, which must be taxed as income from capital assets. The respective interest income must therefore be entered in the appropriate section of the tax return. The income must be reported in the year in which the payment was made by the tax office.
Disadvantages of Interest from the Tax Office
For taxpayers filing a voluntary tax return, it may be particularly attractive—especially given our discussion of potential interest income—to file the voluntary tax return as late as possible, as described. At this point, however, we must point out an important “pitfall.” The “trick” for earning more interest from the tax office should only be used if you are very certain that a tax refund will actually be issued. In the event that a tax underpayment arises instead, the interest calculation principle applies in reverse. In that case, the tax authority won’t have to pay you the interest you were hoping for—instead, you’ll have to pay it to the tax authority. So caution is advised!
Tax Advisors in Düsseldorf and Oberhausen
Do you have questions about tax matters or need assistance with your tax return? We are available to assist you in Düsseldorf and Oberhausen with a comprehensive range of tax consulting services. Our team of qualified professionals is happy to assist you with your concerns. You’ll benefit from our many years of experience. Contact us to schedule an initial consultation. We look forward to hearing from you!
