Doing your federal taxes is always a challenge. You want to find as many deductions as possible without breaking the law. Even though it would be nice to avoid some tax, nobody wants to omit income from his tax statement intentionally. In some cases, that income can include a state tax refund. However, this money is not always taxable. It all depends on how you filed your deductions the year previously.
Your state refund isn't taxable in the year you claim it, but it might be in the following year, when you receive it. Just like most types of income, you pay taxes on the income in the year of receipt.
When you do your tax returns, most state taxes base their return on the federal return, so you do that one first to find your adjusted gross income. At the point you do your return, you only know how much state tax you paid in, not what you actually owed the state.
If you itemize your deductions, you probably list your state tax as one of the deductions. You derive this number from your W-2 withholding statement. Once you calculate your taxes, if you have a refund of the amount you paid to the state, it means you took too much of a deduction off your taxes. The excess amount you deducted would have counted as income if you hadn't listed it as an itemized deduction. It is a recovery of an itemized deduction and fully taxable. When you receive it the following year after filing your taxes, the government wants the tax on that money since you really didn't pay it all to the state.
If you take a standard deduction, that's a bit different. You aren't subtracting all the tax you paid to the state and simply paying tax on your gross income, less the standard deductions and exemptions. You don't have to pay tax on any refund from the state when you use the standard deduction.
Where It Goes
You'll receive the notice of the refund in most cases on form 1099-G. You list the amount on your tax form under taxable refunds, credits or offsets of state and local income taxes on line 10 of the 2010 tax form.
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