Be it because of poor financial planning or poor tax planning, one may end paying more tax than what’s needed. Employers usually ask employees to declare the amount of tax-saving investments planned for the year at the beginning of the year to ensure that appropriate tax is deducted every month. However, this could be tricky and some people may end up under-reporting the amount. This leads to over-taxation and the person becomes eligible for a tax refund. The refund amount, under certain circumstances, becomes eligible for interest, and this interest is taxable.

When does a refund earn interest?

If the amount of refund is at least 10% of the actual tax liability before tax deducted at source (TDS), then the refund is eligible for simple interest. For example, the actual liability was Rs.50,000 but a total of Rs.75,000 was paid as tax. In this case, the excess tax paid Rs.75,000-Rs.50,000 = Rs.25,000) is more than 10% of the actual amount to be paid [(Rs.25,000/Rs.50,000)*100 = 50%]. Here, the payee is eligible for a tax refund along with a simple interest of 0.5% per month, or 6% per annum. Now, say, the refund along with interest was paid at the end of January 2014. The interest amount in this case would be Rs.1,250 (Rs.25,000*0.5%*10 months). Only this interest amount will be taxable. So, if the person is in, say, the 10% tax bracket, she will have to pay Rs.125 as tax on the interest on the refund.

How is the interest taxed?

The interest amount that is paid back is considered “income from other sources”. So, while filing returns for the financial year (FY) in which the refund was given, the interest will be taxable as per the tax slab rate of the person. Say, in the financial year ending March 2013, excess tax was paid and the refund was made in the financial year ending March 2014. While filing returns for FY14, the person will have pay tax on the interest income.

What should you do?

It’s prudent to do tax planning properly. Paying extra tax is not good for various reasons. For one, depending on the case, refunds may take as long as a year to come back to you. If it does not, you may need to follow up with the tax authorities or write to them to get a refund. Second, even if the amount of interest earned on the tax refund is low, you have to pay further tax on it and make the additional effort of filing an appropriate return to be tax compliant.

Apart from that, paying excess tax means that not only does some of your money get stuck, it earns a measly interest of 6% pre-tax. There are various other instruments, such as fixed deposits, which can fetch 9-10% pre-tax. In fact, a fixed deposit for a tenor of five years or more is itself is a tax-saving instrument.