State Tax Refund

[GrayHare]

State tax refunds are considered taxable income (form 1040, line 10). If I'm due to receive a state refund, but instead of receiving it I elect to apply it to current year tax, do the feds still consider the refund as taxable income?

 

[scrabbler1]

It does not matter what you choose to do with the tax refund. It may still be taxable on your federal return.

What does matter is if you itemized your deductions the year before (i.e. the year the tax refund is for). If you took the standard deduction (SD), then the state income tax refund is not taxable. If you did itemize, then all or part of the refund will be taxable. There is a little worksheet in the instruction booklet which has you figure out if all or part of the refund is taxable. What matters there is how close to the SD you were and if you would have taken the SD if you netted out the deductible state income taxes with the tax refund.

 

[GrayHare]

We itemize. Hmm, so the state refund is taxable even if applied to state tax. What makes it confusing is state income tax is deductible on the federal return (sch A, line 5). So, if rather than take possession of the state refund I apply to toward state taxes doing so appears to cancel the tax that otherwise would be due on the refund.

 

[scrabbler1]

If you elect to aply your state income tax refund (for the previous year) to the current year's state income taxes, then that tax payment can be used in your following year's state income taxes itemized in Schedule A (if you itemize in that year). So I suppose it would cancel out.

One thing to be mindful of is that the state income tax refund is considered ordinary income in the following year's federal income tax return. And along with that comes any consequences of having more income which is part of your AGI. This can affect your deductible medical expenses, your ACA insurance subsidy, and other credits or deductions which have phaseouts at higher income levels.

 

[Alan]

We itemize. Hmm, so the state refund is taxable even if applied to state tax. What makes it confusing is state income tax is deductible on the federal return (sch A, line 5). So, if rather than take possession of the state refund I apply to toward state taxes doing so appears to cancel the tax that otherwise would be due on the refund.

Since Fed taxes are filed before State taxes then you don't know what you are going to actually pay in State taxes in any given year so you are always going to be 1 year behind. If I overpaid my State taxes by $1k then when I itemize my deductions I am receiving $1k more in deductions than I will actually pay since within a few days or weeks I am about to receive that $1k back when I file my State taxes.

There shouldn't be a legal way to not have a State tax refund count as income otherwise anyone could deliberately over pay their State taxes, pay less in Federal taxes, and get the State refund.

 

[GrayHare]

One thing to be mindful of is that the state income tax refund is considered ordinary income in the following year's federal income tax return. And along with that comes any consequences of having more income which is part of your AGI. This can affect your deductible medical expenses, your ACA insurance subsidy, and other credits or deductions which have phaseouts at higher income levels.

Thanks, yes, that's been on my mind. The state tax refund adds to AGI whereas the state tax payment (an itemized deduction) does not reduce it. Overpay estimated taxes one year and it boosts your AGI the next even tho it's net-zero income for you.

 

[Animorph]

I tried the apply state refund to future state taxes ploy a couple of years ago. It made no difference to Federal tax treatment (via Turbo Tax). It still added on to AGI the next year, assuming you itemized and deducted it previously. It just meant I cold reduce state withholding a bit the following year.