Q: Tax Playa, why do I have to pay federal income tax on my state income tax refund?
Roger, Boulder CO
A: If you itemized your deductions and claimed a state income tax deduction and received a refund on your state taxes that year, the refund must be included in income the following year. While this sounds odd at first, it makes perfect sense mathematically.
First, the good news. 70% of taxpayers do not itemize their deductions. For these people, state income tax refunds are never taxable.
If you are one of the 30% of taxpayers who itemizes their deductions, though, you probably took a deduction for state income tax paid (usually via your paycheck). No matter how much you paid to the state, the full amount is deductible against federal income.
If, however, you get a refund on your state taxes that year, it means you paid the state too much money. Despite this fact, your state income tax paid was deducted off your return. In order to avoid getting a free extra deduction, the refund must be reconciled by adding it to federal income the next year.
You don't need to keep track of your state refund. The state does that for you by issuing a 1099-G. Many states send this form to all taxpayers who received a refund, itemizers or not. If you are a standard-deduction taker the prior year, you don't need to worry about it.
The converse is also true. If you owe the state money in a calendar year, you can take it as an extra deduction against your federal income, since it was a state income tax paid.
States normally subtract out refunds from their calculation of state taxable income. They also disallow a deduction for state income tax paid.
This creates a planning opportunity if you know you will be in two very different tax situations in two years. Here is an example:
Sam is the recipient of his deceased grandmother's IRA. While normally a 25% bracket taxpayer, the amount of money he has to report from the IRA will push him into the 33% tax bracket this year. As a smart tax planner, Sam pre-pays his entire state income tax for the upcoming year in this unusually high-bracket year.
While Sam will have to report a large state tax refund in the second year, he will pay taxes on that refund in the 25% bracket. Hence, Sam engaged in some perfectly-legal tax arbitrage. He deducted at 33%, and was taxed at 25%. The 8% differential can be large. For every $10,000 he does this for, he lowers his tax bill by $800.