Tax filers are usually somewhat surprised to learn that a state tax refund may be taxable on their federal income tax return. There is sometimes some interplay between the state tax return and the federal tax return. Individuals who itemize their deductions in one year may be required to include some or all of a state refund as income on their federal income tax return the next year.
There is a separate line on IRS Form 1040 to report a taxable state refund. A state refund is sometimes fully non-taxable, and it may sometimes be only partially taxable. A state income tax refund becomes taxable on a federal tax return only if the state refund is a recovery of an amount previously deducted.
Overstatement of an itemized deduction
State income tax withheld or paid is an allowable itemized deduction on your federal income tax return. To the extent that a deducted amount is refunded later, the original deduction is overstated. If any portion of the original state income tax deduction is refunded, you might have taxable income to the extent of the refund amount.
Comparison with the standard deduction
State tax refunds are not taxable to tax filers who consistently claim the standard deduction. All filers are entitled to receive the benefit of at least the standard deduction amount for their respective filing status. For tax filers who itemize deductions, a state refund is taxable only to the extent that the benefit derived from the added state tax deduction exceeds their standard deduction amount.
Benefit derived above the standard deduction
A state tax refund worksheet is included in the instructions for Form 1040 to calculate how much of a benefit was derived from a state refund. If you had other itemized deductions in excess of your standard deduction amount before adding in state taxes, the entire state refund is taxable. If your total itemized deductions exceeded your standard deduction amount only because of the added state tax deduction, only a portion of the state refund is taxable.
The taxable portion of the state refund is limited to the amount by which your total itemized deductions for the year exceeded the standard deduction amount for your filing status. If only a portion of the state refund is taxable, the remaining portion is non-taxable.
Most states issue an IRS Form 1099-G to recipients of income tax refunds after the end of each year. Form 1099-G simply reports the amount of the refund, but it is a good starting point for determining if any of the refund is taxable. Contact a tax preparation service like Tri Check Inc for more information about any aspects of federal or state income tax.