For example, they would claim the total tax withheld on 2008 W-2s and/or 1099s on Schedule A of the 2008 Form 1040, and claim the refund from the 2008 state tax return as income on Line 10 of the 2009 federal income tax return.
This is done under the general rule of “when in doubt- defer”. It is better to pay tax on income next year than this year. You will increase the current tax year refund, or reduce the current year amount due. But this is merely a “loan” – as you must pay the tax savings back on the next year’s return.
However this action should not be automatic each year.
The reason is that a state tax refund claimed as income increases the taxpayer’s Adjusted Gross Income (AGI), and in doing so could negatively affect a multitude of deductions and credits.
For example –
* An additional $1.00 of gross income could mean the difference between a $4000 deduction for tuition and fees and a $2,000 deduction for tuition and fees, or a $2,000 deduction for tuition and fees and no deduction at all.
* The allowable Child Tax Credit will be reduced $50 for every $1,000 AGI exceeds the appropriate threshold amount.
* Because of the way Social Security and Railroad Retirement benefits are taxed every additional $1.00 of gross income could be taxed as $1.85.
In the first example above a $10 taxable state income tax refund could cost $500 in taxes to someone in the 25% tax bracket! In the second example the same $10 could cost the taxpayer $50. And in the third a $400 taxable refund would cost $111 in additional tax to someone in the 15% bracket and not $60.
If at all possible you should prepare the state income tax return first (easier to do in some states than others) and claim an itemized deduction for the actual amount of the current tax year’s state income tax liability instead of the total amount of state income tax withheld and/or paid via estimated tax. This way any state tax refund will not have provided a tax benefit.
Or more better - compare the actual current tax year’s state tax liability to the allowable state and local sales tax deduction, and if the allowable sales tax deduction is greater than the calculated liability, though not greater than the actual amount withheld or paid, claim a deduction for state and local sales tax.
You should keep in mind that if you are a victim of the dreaded Alternative Minimum Tax (AMT) for the current tax year you receive no tax benefit from deducting any kind of tax (or at the very least a reduced tax benefit – depending on the amount of AMT you pay), and therefore there is no, or a reduced, tax benefit from any state tax refund.
And only that portion of a state tax refund that provides a tax benefit is included in income. Let us say that a married couple filing a joint return claimed an itemized deduction of $4000 in state income tax withheld on their 2008 Schedule A. This brings the total deductions on the 2008 Schedule A to $12,300. The applicable standard deduction for 2008, including the additional $1,000 for real estate taxes paid, is $11,900 – so the tax benefit from the $4,000 state income tax deduction is only $400 ($12,300 - $11,900 = $400). If the 2008 state income tax refund is $650, only $400 is includable as income on the 2009 Form 1040.