Your State Refund Could Be Taxable: 2 Ways To Avoid Paying the Government Twice

Receiving a state tax refund can feel like a financial windfall, but it’s important to understand the implications it may have on your federal taxes. Here’s what you need to know to navigate this scenario wisely and potentially avoid paying more to the government than necessary.

Find Out: What To Do If You Owe Back Taxes to the IRS

Is Your State Refund Taxable?

Whether your state refund is federally taxable depends on what you claimed on your taxes in the previous tax year.

Because most people claim the standard deduction, they do not need to pay taxes on their state refunds.

Your state refund is taxable if you itemized your deductions and deducted payments for state tax in the previous tax year. Many people choose to write off their state tax payments to lower their federal taxable income and potentially fall into a lower federal tax bracket.

You may not need to report the entire state refund as income. You only have to report the amount you received that is more than the amount you deducted in the previous year. For example, if you deducted $1,500 in state taxes last year, but your state refund this year was $2,000, you only need to report a tax refund of $500 on your federal income tax return.

How To Tell if You Itemized in the Previous Tax Year

If you can’t remember whether you itemized your taxes last year, there are two ways to tell:

• Look through the previous year’s tax records for a Schedule A. This form is used to file itemized deductions, so if you don’t have the form, you took the standard deduction, and your state refund is tax-exempt.

• Review line 12 of your Form 1040 from the previous tax year. If the number in line 12 matches the standard deduction amount for your filing status — listed in the left-hand margin of the form — you did not itemize, and your state refund is tax-exempt.

How To Avoid Paying Taxes on Your State Refund

There are two ways to avoid paying taxes on your state refund.

1. Take the Standard Deduction

The most common strategy is to take the standard direction instead of itemizing your tax deductions.

2. Itemize Your Deductions, But Don’t Deduct State Taxes

If you need to itemize your federal income tax return deductions, opt not to itemize any state taxes paid during that tax year. You can still deduct any sales tax paid.

How To Report Your State Refund

If you used the same tax software program this year to complete last year’s taxes, it may remember and self-populate your taxable refund.

Otherwise, gather the following:

• The Form 1099-G for any state that sent you a refund in the tax year you’re filing for

• Your tax records from the previous tax year

• The previous year’s federal Form 1040 and Schedule A if you itemized deductions that year

• The current tax year’s Form 1040 with Schedule A Worksheet

• The current tax year’s Worksheet 2, “Recoveries of Itemized Deductions”

Check your previous tax year’s paperwork first. If you see that you itemized your state taxes, use your Form 1099-G to fill out your current tax year’s Form 1040 using the worksheets to help.

Final Take

The best way to ensure you won’t need to pay federal income tax on your state refund is to file your taxes using the standard deduction. If you must itemize your deductions, deduct any state sales tax you paid instead of the state and local taxes. Make certain to keep a record of your taxes from year to year so you can quickly determine if you owe federal income tax on your state deduction.

FAQ

Here are the answers to some of the most frequently asked questions about tax refunds.

• Will my tax refund go to back taxes?

  • If you owe back taxes, the IRS will automatically apply your refund amount to any taxes you owe. For example, if you owe $5,000 in back taxes and your refund is $6,000, the IRS will only send you a refund of $1,000.

• Does everyone qualify for a tax refund?

  • Since tax refunds are technically tax overpayments made through payroll deductions such as the FICA tax, not everyone qualifies for a tax refund. If you did not withhold enough money to cover your annual tax payment, you will owe money at tax time.

• How long does it take to get a tax refund?

  • How long it takes to get your refund varies based on your situation, but the process typically takes less than three weeks.

This article originally appeared on GOBankingRates.com: Your State Refund Could Be Taxable: 2 Ways To Avoid Paying the Government Twice