Line 10 of Form 1040 says “Taxable refunds, credits, or offsets of state and local income taxes.”
So this is where most people put their income tax refund they received.
You: Isn’t that where it goes?
Yes, if it’s taxable.
You: Why wouldn’t it be taxable?
A few reasons actually. First let me explain the concept for why a state income tax refund might be taxable.
Say you itemized deductions last year. This part the state income taxes you paid. Then, you find out that you overpaid your state income taxes and you get some back – that’s your refund. The feds say, “That’s not fair – you already deducted those taxes and they weren’t really taxed you owed – you got them back. So, give me back that deduction you took.” To do so, you have to include the refund in income the next year.
But not everyone falls into this neat simple case. Some have more confusing facts.
You: But if I have more confusing facts, won’t my tax software catch this issue properly?
It should, but it might not. It will partially depend on whether you did your return last year with the same program and what data you enter where.
You: What if I used a paid preparer?
I’ve seen paid prepares miss this too – twice in the last three weeks.
You: So what might cause my state income tax refund to not be taxable?
One example: If you didn’t itemize last year, you don’t have to pay tax on your income tax refund this year. This is true – even if you do itemize this year. That’s just one reason why every competent tax preparer requests a copy of your prior year return if he/she didn’t do it.
A second reason: you might be in AMT.
You: What’s AMT?
The alternative minimum tax.
You: Is that a bad thing or a good thing?
Mostly, it’s a bad thing – except when it comes to state income tax refund, when it’s a good thing.
Taxpayers in AMT don’t receive any tax benefit from their state income tax deduction.
You: That part sounds bad.
It is bad. But, as a result, part or all of their state income tax refund isn’t taxable the following year. Figuring out how much of the income tax refund is taxable is a complicated process that more or less requires one to recompute the prior year’s tax liability as though the amount previously deducted for regular tax purposes was not.
You: If I understood you correctly, that’s crazy.
I agree. If you understood that last sentence, that is crazy.
You: That’s not what I meant.
I know. Nonetheless, don’t just absentmindedly include that refund. You might just overpay on your taxes. To me, that’s crazy.