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. :)