Why is my State Refund Taxable?

It feels like I'm being taxed on money I already paid taxes on!"

"What is the point of getting a state refund if I have to pay income tax on it?"

The premise behind these two common complaints is not true, but these complaints show one thing for certain: people resent having to report their state refund check as income. Sometimes after I explain it logically, I get one final comment that goes something like this: "Well, thanks for explaining it. I understand now, but I still don't like it and I plan to argue with you about it again next year."

"Refund" and "overpayment"
The states and the IRS use the words "refund" and "overpayment" interchangeably. The overpayment is what is taxable. For example, a taxpayer has a $2,000 state overpayment and gets a state refund of $2,000. For reasons described below, the $2,000 is taxable. Now let's say that the taxpayer elects to give $500 of his overpayment to the Wildlife Fund, or the Orphans' Fund, or the Firefighters' Fund. His refund will then be only $1,500. Even in this case, the $2,000 is still taxable even though he can deduct the $500 somewhere else on next year's return as a charitable contribution.

How the deduction works

  1. One deduction allowed on your itemized deductions is state income tax you pay for the year.
  2. Before you can prepare your state tax return, you have to first prepare your federal return.
  3. You cannot prepare your state return first and your federal return second.
  4. When you are preparing your federal return, you do not know yet how much state income tax you are going to pay for the year.
  5. So the IRS allows you to "guess" the amount for now. If you overguessed or underguessed, you make the adjustment on next year's return.

    Stop for a moment. Doesn't this make sense so far?

  6. But the IRS tells you exactly how to "guess" your state tax.
  7. For most people, deduct the amount of state income tax withheld during the year.

    Here's the problem:

  8. You had $3,000 state tax withheld during the year, so you deduct that as an itemized deduction.
  9. Later when you prepare your state tax return, you find out that your state income tax was only $2,000, so you are going to get a refund of $1,000.
  10. Your state income tax is only $2,000 for the year but you deducted $3,000.
  11. To straighten this out, the IRS lets you report the $1,000 overpayment as income next year.
Still not convinced?

If you still think that the overpayment is taxable or should be taxable, then try this scheme. It will not work, and that is the point. This extreme example will probably make it clear.

  1. A taxpayer gets an annual salary of $50,400.
  2. His gross each month is $4,200.00.
  3. He has $840.00 combined federal income and social security taxes withheld.
  4. This leaves a take-home of $3,360.
  5. He goes to his employer and says,
    1. "Each month I want you to hold out $3,359 state income tax so that I get a check for $1.00.
    2. I will borrow money from friends and family to live on during the year.
    3. At the end of the year, I will have a state tax deduction of $40,308. I won't owe any income tax.
    4. Then I'll file my state return and get a refund of $40,308.
    5. I'll pay my friends back and I will have saved over $10,000 in taxes.

Didn't get a 1099-G?
If you did not get a form 1099-G from the state reminding you of the amount of your overpayment, it does not matter. The overpayment is still taxable.

What if I did not itemize last year?
If you did not itemize last year, then you did not deduct any state tax. Therefore you do not have to "adjust" the amount you deducted. If you did not itemize last year, then your state refund or overpayment is not taxable this year.

Hopefully it makes sense to you now. If this scenario were true, then wouldn't banks replace their billboards that say "The more you IRA, the less you IRS" with "Make a state tax refund loan with us and pay no taxes at all!"?