Under what circumstances is NYS Refund taxable?

Question

I don't itemize deductions for Federal and NYS Taxes.

Is NYS Refund still taxable?

Under what circumstances is NYS Refund taxable?

My co-worker says NYS Refund is taxable after $63, but I cannot find this documentation anywhere.

Please clarify.

Answer 1

At the federal level, a state tax refund is not taxable per se. What can affect your taxes is if you claimed a deduction for state and local taxes based on withholdings (which is common), and then got a refund because too much was withheld. That means that you claimed a deduction that was higher than what you actually owed in state taxes. Your refund then represents taxes that should not have been deducted, and might be "taxable" to reverse that deduction (the 10K SALT limit might mean that the refund is not taxable if your total state/local taxes were over the 10k limit anyway).

If you do not itemize, then you did not claim a deduction for state taxes, and thus your refund had no bearing on your tax owed.

There might be some specific situations (e.g. dual state incomes) where a state refund might be taxable in New York, but at the federal level it's only "taxable" if you would have owed more tax had you not gotten a refund (meaning you would not have deducted more than you paid)

Answer 2

Tax refunds are not taxable because they are YOUR money

You only file taxes once a year, but the government needs money all year. Therefore they have you make quarterly tax payments, or do paycheck withholding. All these payments are still your money - they are simply being placed on deposit with the IRS or state to cover the tax bill they expect you to have at the end of the year. They only become the state's money when you file your taxes.

And, that withholding is taken from money you already paid taxes on. So they can't tax your refund - that would be taxing the same money twice!

However, there's a weird exception

If you itemize deductions, the Federal government allows you to deduct the taxes you paid to a state on your Federal Schedule A. That's fair and simple enough. If your state tax was $2411.06, just enter that line on Federal Schedule A and happy dappy, right?

Problem, though. In most states, you must do the Federal taxes first including Schedule A. (because the state form lifts numbers off the Federal form). So if you haven't done the state taxes yet, how do you know what number to put in Schedule A? You could do it all in pencil, and when you're finished come back and update the number in Schedule A, but that would change everything below it, invalidating what you put in schedule A! You'd be stuck in an infinite loop. (actually, seriously, if you did it enough times it would converge on a single number which would be correct. Maybe a half dozen iterations with whole dollar rounding. But IRS can't tell you to do that!) *

So. The practical workaround to this is to state on your Federal Schedule A what state taxes were withheld, on the hopes that these will be reasonably near the actual state tax. Then, the next tax year, you do an adjustment to correct that amount. Got it?

What does that adjustment look like? The state tax was not taxed Federally, so if you got a state refund, that money never had taxes paid on it, so you owe tax on it the next year.

This only applies to a state tax refund issued for a tax year in which you itemized deduction of state tax.

So for example if in tax year 2021, you itemized and deducted $2800 of state tax, but on April 2022 you got a $388 state tax refund. You hadn't paid taxes on that $388, so it's taxable income on your tax year 2022 taxes.

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* And I have done that, actually. I sold some options and donated those to charity, so my withholding was 4 times what my taxes would be. Rather than deduct the entire state withholding (which would have thrown me into AMT), I did a couple iterations, found out my state tax would be within $20 of $2000... so I claimed a deduction for $8000 less than my actual state withholding was. And that worked. Problem was, next year I declared $8000 less than my actual state refund, and I didn't adequately explain why I did that, so a particularly dull auditor at Andover failed to see what I did there. I had to take them to tax court, which was like shooting fish in a barrel since I was correct. IRS counsel said "oh yeah, you're right, go ahead and write the judge's order".

Which is a lesson: most people would be curled up in a ball whimpering if they ever had to deal with tax court or an IRS counsel. They're actually really nice. All they care about is tax law being complied with.

Well, the other lesson is that the tax "instructions" are not tax law, and are simplifying the very dense tax law for the vast majority of people. It's absolutely possible to have a corner case like mine where the instructions do not do as law intended. I was able to intuit that this applied to me, did the research and was well compensated for my trouble (vs paying double tax due to glitches). Anyway the education I got was worth 10 times it. Never fearing the IRS again - priceless.