Question About State Income Tax Deduction

[Gen Y Finance Journey]

My husband and I are going down to one income later this month, so we're figuring out how to adjust our tax withholding for the rest of the year. Last year was the first year either of us itemized our deductions, and now this is the first time I've ever really made an effort to truly understand withholding allowances. So I'm spending time going through our 2014 tax return to understand what every line means. But in doing this, I realized something interesting about our state income tax deduction...

Last year we overpaid on our state income taxes by a few hundred dollars and got a refund. But we deducted the amount of state income tax we paid out of our paychecks on our federal taxes, not our actual state tax liability. As a result, we reduced our federal tax burden by 25% of the amount we overpaid on state taxes. If we hadn't overpaid and invested that money instead, we wouldn't have been able to get a 25% return on it, so we came out ahead.

So my question is: is this a loophole, or is it completely illegal but because we only overpaid by such a small amount nobody really cares? Would drastically withholding on your state taxes throughout the year so you can claim it as a deduction on your federal taxes trigger a fine or an audit? Would it be tax fraud? Finding answers to simple tax questions online is hard enough, I haven't been able to find anything at all about this. :)

[Cheddar Stacker]

Since you overpaid the state tax, you reported a refund on your 2014 state return. In early 2016, you will receive a tax form for 2015 listing this refund. This will be taxable income on your 2015 federal return.

You got a deduction for the amount paid (which is what you are supposed to do) so you have to pay tax on the amount that was paid back to you.

There are exceptions, but this will likely be taxable. The good news is that you might pay 15% tax on it since your income is dropping, so you might save 10% on this overpayment.

[johnny847]

What Cheddar Stacker said.

Some people game this by setting their state withholding high during their last working year. Sleezy but as far as I am aware, legal.

[forummm]

Small addendum: Only the amount of the refund that exceeds your standard deduction is taxable. So (making up numbers here) if your standard deduction was $12k last year and your itemizing made your itemized deductions $12500, and you got a $1k refund from the state, only the $500 would be taxable the following year.

[Gen Y Finance Journey]

Since you overpaid the state tax, you reported a refund on your 2014 state return. In early 2016, you will receive a tax form for 2015 listing this refund. This will be taxable income on your 2015 federal return.

You got a deduction for the amount paid (which is what you are supposed to do) so you have to pay tax on the amount that was paid back to you.

There are exceptions, but this will likely be taxable. The good news is that you might pay 15% tax on it since your income is dropping, so you might save 10% on this overpayment.

Ok, that makes sense. And yes, we will be in the 15% bracket this year so we'll save a very small amount of money. I'll claim that as a victory!

[Cheddar Stacker]

Small addendum: Only the amount of the refund that exceeds your standard deduction is taxable. So (making up numbers here) if your standard deduction was $12k last year and your itemizing made your itemized deductions $12500, and you got a $1k refund from the state, only the $500 would be taxable the following year.

Since you brought one up, I'll bring up a few more:

-If you use the standard deduction a refund from that year is not taxable.
-If you pay AMT the state taxes wouldn't be deductible anyway, so the refund isn't taxable.
-If your "sales taxes paid" exceeds, or is close to the state income taxes, your refund might be non-taxable or only partially taxable.