Some tax filers are surprised to learn that a state tax refund might be taxable on their federal income tax return. It initially seems counterintuitive, since state and federal tax returns are largely independent of one another. Individuals who itemize deductions should prepare for the possibility that some or all of a state tax refund could be included as income on their next federal tax return.
Form 1040 has a specific line used exclusively for entering the taxable portion of a state refund. The entry line is applicable to tax filers who itemized deductions in the preceding tax year and consequently received a state refund. In contrast, tax filers who claimed the standard deduction in the preceding year are not taxed on a state tax refund.
Applicability to itemized deductions
Each tax filer is entitled to deduct at least a basic standard deduction amount. Alternatively, individuals may choose to itemize their deductions if the total exceeds the standard deduction for their filing status. A state tax refund is taxable only to the extent that it causes your itemized deductions to exceed your allowable standard deduction.
Correction of an itemized deduction
For individuals who itemize, state income taxes withheld or paid during the year are typically deducted along with other itemized deductions. If a portion of the state tax deduction is returned later in the form of a refund, the original deduction is no longer fully justified. The entire state refund might not be taxable, so a few calculations are necessary to determine exactly how much to report as income.
Calculation of additional income
First subtract your state income tax deduction from your total itemized deductions. If the subtraction result is greater than your standard deduction, all of the state refund is taxable. This indicates that you received an earlier tax benefit for the full amount of any state tax refund received. If the subtraction result is less than your standard deduction, only a portion of the state refund is taxable.
The amount of your state tax deduction that simply elevated your itemized deductions up to the standard deduction amount are not adding any additional benefit. However, a state tax deduction that pushes your total itemized deductions above your standard deduction results in a tax advantage. That portion of the deduction in excess of the standard deduction becomes taxable to the extent you later get it back.
The calculations to determine taxability of a state refund are fairly straightforward, but there are also various worksheets available that produce the same result. Other aspects of tax returns can also affect subsequent years, making it important to rely on the same tax preparer from year to year. Contact a tax like Jeffrey Beebe CPA for additional information.