A state tax refund might be considered taxable income on your federal return. It depends largely on whether you took a federal tax deduction for the state taxes in the year you paid them. If you did, you'll have to fill out an Internal Revenue Service worksheet to determine how much of the refund is taxable. But if you didn't deduct the state taxes in the first place, then your refund isn't taxable.
The IRS allows you to deduct from your federal taxable income certain taxes that you pay to state and local governments. If you pay $3,000 in state income tax, for example, you can reduce your federal taxable income by $3,000, which in turn reduces your federal tax bill. The point of the deduction is to prevent you from having to pay taxes on the same money twice. However, if you later get a refund of any of those state taxes, you'll probably have to add at least some of it back in to your federal taxable income.
When It Isn't Taxable
You can claim a federal deduction for state tax payments only if you itemize your deductions using IRS Schedule A. Therefore, if you didn't itemize your deductions for the year for which you are receiving the refund, then your state refund will not be taxable. Furthermore, if you itemized your deductions but didn't claim a deduction for the taxes that are now being refunded, then your refund isn't taxable either. For example, Schedule A allows you to deduct either your state income taxes or your state sales taxes, but not both. If you chose to deduct sales taxes for a given year, but later received an income tax refund for that year, then the refund is not taxable.
Figuring the Taxable Amount
If the refund you received is a refund of state income taxes paid in the previous year, use the "State and Local Income Tax Refund Worksheet" included in the instructions for IRS Form 1040 to determine how much of your refund is taxable. If you received a state income tax refund for any other year, or if you received a refund of some other state tax that you had deducted, such as sales taxes or a state property tax, see the instructions under "Itemized Deduction Recoveries" in IRS Publication 525. In no case will the amount you have to report exceed the amount you originally claimed as a deduction.
Reporting the Refund as Income
If you get a refund of tax money you previously deducted, you don't have to go back and file an amended federal return for the year in question. You report the refund as taxable income on your federal return for the year in which you received it. Report the taxable portion of your refund on Line 10 of your Form 1040 federal tax return.