<p>As far as I know, yes, you are supposed to pay income taxes on the amount of the refund in the year in which you get the refund. Take 2005, for example. The extra amount withheld in 2005 is deducted from your income in 2005 as taxes already paid. So you didn't pay taxes on that extra amount in 2005. When you got it back in 2006, it is now added income in 2006, on which you need to pay taxes (because you didn't pay in 2005).</p>