January 29, 2007

A Taste of Tax

A tax question came up on Keri’s show today and I thought I would address it here, because when I first heard it I couldn’t remember the answer. This forced me to find the answer and remind myself. I’ll try to make this post clear, but you might want to save reading this for later if you get insomnia.

Disclaimer: I am not qualified to give tax advice, so before you take my word for anything, consult with an appropriately licensed accountant.

If I understood correctly, a fellow on the show said he was being charged back taxes because he had (year after year) failed to include his tax refund (he said “tax return” but he meant “refund”) as income on his tax forms.

In other words, he was saying that if you overpaid your taxes through payroll deductions in 2005, and you get a refund check for that over-payment in 2006, when you do your taxes in 2007 you must claim that refund check as income.

This rang a vague bell with me, because I do my own taxes and remember entering a refund check amount somewhere. However, that description as stated above is inaccurate although close to the truth. I called up my dad, who loves to read the tax rules, and he reminded me of the rule I was thinking of that sounds similar to the above situation.

Check out this stepwise explanation of situation the guy was probably really in - a common situation for people who itemize:

  1. In 2006, you itemized your federal taxes for 2005, and you deducted your state taxes from your federal income. You didn’t know exactly what you were paying in state taxes, because you hadn’t done your state taxes yet, so you put down your withholding from your W-2 and count that as your state taxes.
  2. Next you did your state taxes for 2005. You itemized them. Hey, you got a refund!
  3. Your refund check came in the mail later in 2006.
  4. In 2007 you now want to do your federal taxes. Last year you claimed all your state withholding as your state taxes. But wait! You didn’t really pay that whole amount to the state on your 2005 state taxes because when you itemized your state taxes you got a refund. You overstated your state tax payment when you reported it to the federal government. You had to because you didn’t know exactly what your state tax payment would be. But now you do know what it was; you’ve already gotten your refund. Your refund is the amount of overstatement. So you treat that refund as 2006 income, but really it was 2005 income that the government allows you to carry over a year.

So if the question is “why do I have to report my 2005 state refund on my 2006 state taxes” - you don’t. That doesn’t make sense. That refund is part of money that has already been taxed by the state.

If the question is “why do I have to report my 2005 federal refund on my 2006 federal taxes” - you don’t. That doesn’t make sense. That refund is part of money that has already been taxed by the federal government.

But if the question is “Why do I have to report my 2005 state refund on my 2006 federal taxes?” the simple answer is “because that’s income you had in 2005 that you mistakenly deducted from your federal income when you itemized.”

Why does the government allow this? Because you need to finish your federal taxes before you do your state taxes. If there were a line on your federal taxes that required you to know how your state taxes were going to come out after itemizations, you’d have a circular calculation. You couldn’t do it. So the feds allow you to use your state withholding as an estimate of your state taxes. Then they require you to make up for the difference next year. In fact, it’s likely that you’ll get a 1099G in the mail from your state reminding you of that refund amount. The 1099G also goes to the IRS… so beware. They have also been reminded by your state that you were issued a refund. (MA does this, I don’t know if other states do)

I have actually simplified the explanation here quite a bit. There are exceptions, and this only applies if you itemized your federal taxes in the previous year.

So, simplified: If you itemized federal last year and got a state refund, you’re most likely going to have to include that refund when you’re reporting your income when you do your taxes this year.

An exception to this is called the “Tax Benefit Rule” and you can read some of that in the following links:

This post brought to you by the numbers 10 and 40, the letters EZ and the disorder known as insomnia.

Posted by James at January 29, 2007 7:04 PM
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Comments

I had also been mistaken and my mom told me the same as your father when I called her.

Posted by: Sara at January 30, 2007 9:51 AM

If you overpay your state income taxes, and receive a refund from the state in the previous year, you have to claim it as income, but ONLY if you used your state income taxes as part of your itemized deductions in the previous year. If you took the standard deduction, you had never gotten any tax benefits from claiming your state income taxes and don't have to declare the refund as income.

Posted by: frazzledspice at January 30, 2007 9:58 AM

And there's an additional wrinkle, at least in NY — maybe it's the same in MA:

You must record the same numbers on your NY State tax return as are on your federal tax return. That means that

  1. you must include the deduction for state income tax that you took on your federal return, even though it's not allowed by the state, and
  2. you must include the income claimed on the federal form for the state tax refund, even though it's not taxable by the state.

There are then separate places on the state form where you add back the state-tax deduction, and where you deduct the state-tax-refund income. It's an area where many Noo Yawkahs make mistakes on their tax returns.

This is all part of the New York State Paperwork Increasement Act of 1749. Excelsior!

Posted by: Barry Leiba at January 30, 2007 2:14 PM

Wow - that's on par with some of the most confusing Massachusetts tax form instructions.

I feel a paper cut coming on just thinking about it.

Posted by: James at January 30, 2007 2:37 PM

Thanks for explaining that. It always puzzled me. I felt like I was being taxed twice on the same money, but now it is clear.

Posted by: briwei at January 30, 2007 5:23 PM

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