Is My State Tax Refund Taxable and Why?

Tax Tips

For itemizers, it’s one of the stranger parts of the tax code. First you get to take a deduction of your state and local taxes, then all of a sudden the next year you get a 1099-G from your state and you’re paying taxes on your state and local tax refunds. What gives?

The bottom line is that, in general, the amount of state and local tax you deduct from your federal return is based on the total amount you paid to your state in estimated taxes and withholding rather than your actual state tax. So if you end up getting a state refund, you really ended up deducting more on your federal return than you should have.

There are times when your state and local tax refund is not taxable, though, and we’ll cover that first.

In general, if you didn’t deduct state and local income taxes last year, you don’t need to pay taxes on your refunds this year. For instance, if you didn’t itemize your deductions in 2006 (you took the standard deduction) then your state refund is tax free this year.

Also, if you deducted your sales tax and not your state income taxes on your 2006 Schedule A, your state refund is not taxable for 2007!

So that’s pretty easy. It gets more complicated when you actually do have to pay taxes on your state and local refunds. Why? Because sometimes your total refund is taxable and sometimes only part of you refund is taxable.  If all of the following statements are true, then your total state and local refund is taxable:

  1. In 2006, you had federal taxable income.
  2. The state and local refunds that you received (and were reported on your 1099-G) were equal to or less the state and local taxes that you deducted on your Schedule A in 2006.

For example, your 2006 state tax deduction was $1,000 and your refund is a $1,000 or less. In other words, you’re don’t have to pay taxes on refund money you didn’t deduct in 2006.

  1. Your 2006 itemized deductions exceeded your 2006 standard deduction by at least your refund received.
  2. For example, your state refund was $1200, your 2006 standard deduction was $5,000 and your itemized deductions were more than $6,200
  3. Your 2006 itemized deductions were not limited. On your 2006 Schedule A, line 28, the “no” is checked indicating that your deductions were not limited.
  4. You did not pay any Alternative Minimum tax in 2006. Your 2006 Form 1040, Line 45 was blank.
  5. You paid all of your 2006 state tax payments in 2006.

You didn’t pay your 4th quarter 2006 state estimate payment in 2007. You also didn’t pay a 2006 state extension payment or a 2006 state balance due in 2007.

If all of the above are true, you’re paying tax on your total refund.

So what happens if any of the above statements are not true with your tax return?  Then TurboTax performs calculations to determine how much of that refund is taxable.

If you are curious about these calculation and you are using the desktop TurboTax product, go to Select Forms (top tool bar in TurboTax), select Open Forms, scroll down to and highlight the State Tax Refund Worksheet and click Open.

Follow line by line down the State Tax Refund Worksheet and you’ll see how TurboTax determined the amount of your refund that is taxable. For help on a particular line item, right-click on the field and select “about line xx.”

For more information, see IRS Publication 525 under Miscellaneous Income, Recoveries.