Bob O'Brien
Head Instructor
bobrien@mywealth.com
Taxes on top of taxes, what is this? Ever really wonder why, you have to pay taxes on your state tax refunds? Have you ever received a 1099G? I have noticed that this is something that really blows people’s minds and it is really not that complicated at all.
In fact it was one of the most popular questions that I had in an article that I wrote last month for the “Dumb Little Man” blog and I am going to elaborate here exactly why a state tax refund can be taxable. Before I get into an example, there are three basic points we need to be certain that we understand.
First of all if you work in states like Florida or Texas and you pay no state income tax, this does not apply to you. But please read on, because I talk about another deduction that you should make certain you are getting. However, it is possible this could happen on your property tax or even sales tax, but not very likely.
Secondly, you need to be clear in the fact that local taxes are tax deductible at the federal level. Real Estate Taxes, City Taxes, Property Taxes (can be on an auto in some states), State Income Taxes or Sales Taxes are all tax deductible on Schedule A as “Taxes You Paid”.. When it comes to sales and state taxes you cannot take both. Generally you should take the higher of the two (state income taxes or sales taxes and see below). Also, remember that local taxes are much higher than ever before in history!
Thirdly, if you did not itemize your return the year before, the state tax refund will not be taxable. You would only itemize your return in 2008 if your itemized deductions exceed $5,450 filing single and $10,900 filing jointly, otherwise you would just take the standard deduction. If you took the standard deduction you do not have to add back your state tax refund.
Okay, now that we understand the former three paragraphs… Let’s say in 2008 you made $100k and withheld $10k in state income tax. You deducted $10k as taxes paid in 2008, because that is what you paid in state income tax for 2008. You then calculate your state income tax for 2008 and determine that you owe $8k in state income tax. You will get $2k back from you state, because you withheld $10k correct?
HA-HA!… starting to see it now? You took a deduction on the federal for $10k, but you really only owed $8k and got $2k back. You really took an “over deduction” of $2k for more than you were entitled to. Legally, this is the way taxes are calculated. You do the federal return first and then the state return afterwards. You then have to add the $2k as income to the next year and you are reminded to calculate this with form 1099G.
In conclusion to this example, you took a deduction for $10k because that is what you paid in state states in 2008. Then you got $2k back from the state in 2009. $2k is taxable in 2009 on the federal return (assuming you itemized your return).
This is really no different, than taking the sales tax deduction last year on a big ticket item and then returning the big ticket item in the next year in which you get all your money and sales tax back… but you already deducted the sales tax last year. You should then add it back when received that year, because you never really paid it, and yet it was deducted from income the year before.
Remember you can only take sales tax or state income tax deduction and not both. (Generally take the higher of the two). If you live in a state with no state income tax like Florida or Texas, make sure you are deducting your sales tax. It can really bolster your return.
I hope this makes sense, and any decent tax computer program will simplify this for you. I wrote this article because people asked me this all the time and I never had the time to explain it in detail when I was preparing their return. It really is a great example of the checks and balances that go on behind the scenes. When this is understood, it increases your tax IQ and that will save you “big money” in the long run.
By the way, this can get even a little more complicated. If you are subject to the Alternative Minimum Tax (AMT), the state income tax deduction is added back into the AMT. Stay tuned for future articles on the AMT.
Please post any comments below, and topics for articles that you would like to see written. And check out our courses!
Sincerely,
Bob O’Brien
Sr. Instructor
