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Context: I am calculating what my taxes will be next year (2021) for purposes of filling out my W-4s such that my withholdings will be as close to my actual tax liability as possible, to minimize my tax refund. I live in Oregon.

I am going to be itemizing deductions for the tax year of 2021, rather than taking the standard deduction. This means that I can deduct my Oregon income tax (OIT) from my federal income tax (FIT) liability. However, in a handful of states, including my state of Oregon, I can also do the reverse: I can deduct my FIT from my OIT liability... which will then in turn re-affect my FIT liability, which will again re-affect my OIT liability... in other words, it creates a seemingly circular dependency.

My question is: What is the correct way to resolve this? Or, more specifically, Is the way I resolved it, the correct way?

My solution was to first calculate my OIT liability without deducting FIT, and then calculate my FIT liability including the deduction of my OIT, to get my initial calculated amounts. These were approximately an OIT of $4400 and an FIT of $5000. I then recalculated my OIT by deducting my FIT, and then adjusted my FIT wit the new OIT, and rinse and repeat until I reached a stable amount for each tax liability where the result of adjusting the one no longer changed the amount of the other. The end result was an OIT around $3900 and an FIT around $5100 (in other words, about $400 total less than owed tax than when I started).

So my question is, is this the right way to resolve this circular dependency, via recursion?

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The federal deduction for state taxes is not determined by your state tax liability, but by the taxes you actually paid (or had withheld from your paychecks) during the calendar year, so the payment you will make to your state in early 2021 for the 2020 tax year will be deducted on your 2021 federal taxes, not your 2020 federal taxes.

Your federal tax liability for 2020 won't be changed by what you pay to the State of Oregon, provided you wait until after Jan 1 to pay any taxes due to Oregon.

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    @JamesDunn, but are you filing your federal taxes before Dec 31, or can you wait and file between Jan 1 and Apr 15? – The Photon Dec 16 '20 at 0:24
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    @JamesDunn, Your withholding isn't expected to be perfectly accurate. Just fill it in "close enough" and pay the difference or get a refund when you file like everyone else. – The Photon Dec 16 '20 at 0:27
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    Or make sure you make enough money that your federal tax liability is more than $6800, which maxes out the Oregon deduction, and then small changes in your federal taxes won't affect your Oregon liability. – The Photon Dec 16 '20 at 0:28
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    What's correct for your federal taxes is to use the amounts actually paid to your state during the calendar year. I don't know for the state of Oregon whether it's based on actual payments or on the liability for the tax year. – The Photon Dec 16 '20 at 0:28
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    Yes, but your refund check from the state will be federally taxable in the year that you receive it. – The Photon Dec 16 '20 at 0:35

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