Why is my state refund taxable?
If you’ve ever received a 1099-G from your state taxing authority, you may be wondering why you’re receiving this form. Do you really have to pay taxes on top of taxes?
First, if you work in states with no state income tax (like Nevada, Florida, Texas, etc.), this does not apply to you.
Second, it’s important to understand that certain taxes you pay are deductible at the federal level. This includes real estate taxes, city taxes, license fees on car registration, state income taxes, sales taxes, etc...All are deductible as itemized deductions under “Taxes You Paid”. When it comes to state income taxes and sales taxes, you cannot take both.
Third, if you did not itemize on your tax return the year before, the state tax refund won't be taxable. You would only itemize your return if the total of itemized deductions exceeds your standard deduction. Click here for more on that. So, if you took the standard deduction, you don't have to worry about your state refund being taxable.
Now that you understand the above three items, let’s move on to an example.
Let’s say in 2017 you made $75k and withheld $7k in state income tax. Assuming you itemized deductions, you would have deducted that $7k as taxes paid on your 2017 tax return, because that’s what you paid in state income tax for 2017.
You then calculate your state income tax for 2017 on your tax return (prepared in 2018) and determine that you owe $4k in state income tax. Because you only owe $4k, but had $7k withheld from your pay for state taxes, you will get a $3k refund from your state for the $3k over-withholding.
So you took a deduction on your 2017 federal tax return for $7k, but you really only owed $4k, and got $3k back as a refund the following year, with the filing of your tax return in 2018. Therefore, you only paid a net of $4k in state taxes, which means you essentially took an “over deduction” of $3k on your 2017 tax return.
To reconcile this difference, that $3k refund you received in 2018 (for the 2017 tax return) is included on a 1099-G form for 2018, which you must claim as income on that 2017 tax return.
This gets even more complicated if you’re subject to Alternative Minimum Taxes (AMT), as the state income tax deduction is added back into the AMT. Contact us if you have questions on this...we’re happy to help!