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I used TurboTax for filing my taxes this year (for 2014) and came across an oddity that either means TurboTax is buggy or the IRS penalizes for overpaying state income tax.

When using turbotax (and in general when doing your taxes I guess) there is a stage where you need to calculate the portion of your state-refund (from previous year, in this example for 2013) that is taxable on your federal tax return (for 2014). If you happened to pay alternative minimum tax in the previous year (2013) that calculation becomes complicated, because you might need to perform a "recalculation of the AMT" in order to find out the portion of the state refund that is taxable on the federal return.

How this recalculation is performed is the source of my confusion. According to turbotax it goes more or less this way. Go back to your previous year's return (using their 2013 software) and write down the state refund you got as a negative number (lets call this number "modification amount" or MA) in some state tax payment column on your previous year federal return. The way I see it, what this does conceptually is to calculate your previous year's taxes as if the amount of state taxes you paid exactly equaled the amount of money you owed your state. After doing the recalculation turbotax asks whether the amount of federal taxes you owe changed or not (which is equivalent to whether your federal refund amount changed or not). If it hasn't changed, turbotax tells you that all your state tax refund is taxable. If it has changed you need to start playing with the MA (increasing/decreasing it and doing the federal tax recalculation each time) until you find a modification that changes the amount of federal taxes you owe change by exactly $1.

My problem is with the former situation where the federal taxes you owe doesn't change and all of your state refund is taxable (although this also means that the latter situation is also problematic but it's harder to show the issue). I'll try to highlight the issue by showing an example with hypothetical tax rates (federal, state and AMT) and how the procedure is flawed.

Lets say that someone is making 100K and his federal tax rate is 33.33% (exactly a third), his state tax rate is 10% and that the AMT rate is %30. Also, lets assume that this person is making the same amount year after year and that the tax rates remain the same. Also, let assume tax returns are filed on Jan 1st (instead of April 15th) and that the money (refunds or money owed) are moved on that same day. Theoretically this person would deduct the 10K state taxes from his federal return (100K-10K=90K) and pay the federal tax rate on that amount, which will come out to be 30K (90K * 33.33% = 30K). 30K is also exactly equal to the AMT rate on the full income without the state tax deduction (100K * 30% = 30K). So theoretically this person should have 60K left in his bank each year after paying all his federal and state taxes from his 100K salary. In a table this looks like this:

FTP - Federal Tax Payments
STP - State Tax Payments
PYSR - Previous Year State Refund
RTIWD - Regular Taxable Income With Deductions (deducting state tax payments)
AMTTI - AMT Taxable income
RTA - Regular (federal) Tax Amount
AMT - Alternative Minimum Tax
AMTR - Alternative Minimum Tax Relationship (RTA <=> AMT)
FTL - Federal Tax Liability
FTR - Federal Tax Refund (negative means you owe IRS money, positive means you get a refuned)
STR - State Tax Refund
MIB - Money In Bank

+------+--------+-----+-----+------+-------+-------+-----+-----+---------+-----+-----+-----+-----+
| year | salary | FTP | STP | PYSR | RTIWD | AMTTI | RTA | AMT |  AMTR   | FTL | FTR | STR | MIB |
+------+--------+-----+-----+------+-------+-------+-----+-----+---------+-----+-----+-----+-----+
|    1 | 100K   | 30K | 10K |    0 | 90K   | 100K  | 30K | 30K | RTA=AMT | 30K |   0 |   0 | 60K |
|    2 | 100K   | 30K | 10K |    0 | 90K   | 100K  | 30K | 30K | RTA=AMT | 30K |   0 |   0 | 60K |
|    3 | 100K   | 30K | 10K |    0 | 90K   | 100K  | 30K | 30K | RTA=AMT | 30K |   0 |   0 | 60K |
+------+--------+-----+-----+------+-------+-------+-----+-----+---------+-----+-----+-----+-----+

Now lets see what happens when he underpays or overpays his state taxes (because of direct state tax payments made from his paychecks). Lets say that he only paid 30K federal tax and 7K state taxes throughout year 1:

+------+--------+-----+-----+------+-------+-------+-----+-----+---------+-----+-----+-----+-----+
| year | salary | FTP | STP | PYSR | RTIWD | AMTTI | RTA | AMT |  AMTR   | FTL | FTR | STR | MIB |
+------+--------+-----+-----+------+-------+-------+-----+-----+---------+-----+-----+-----+-----+
|    1 | 100K   | 30K | 7K  | 0    | 93K   | 100K  | 31K | 30K | RTA>AMT | 31K | -1K | -3K | 59K |
|    2 | 100K   | 30K | 10K | -3K  | 87K   | 100K  | 29K | 30K | RTA<AMT | 30K | 0   | 0   | 60K |
|    3 | 100K   | 30K | 10K | 0    | 90K   | 100K  | 30K | 30K | RTA=AMT | 30K | 0   | 0   | 60K |
+------+--------+-----+-----+------+-------+-------+-----+-----+---------+-----+-----+-----+-----+

See what happened? 1K vanished when compared to the theoretical case where he always pays what he should pay throughout the year. Bottom line, if you underpay your state taxes, IRS might penalize you through AMT in the following year.

You might say, well OK, the guy underpaid his taxes, he shouldn't have done that, it's not bad deadbeats get penalized. Fine, lets see what happens when someone overpays his state taxes (his employer deducts too much state tax from his paychecks).

Lets say that he paid 30K federal tax and 13K state taxes throughout year 1:

+------+--------+-----+-----+------+-------+-------+-----+-----+---------+-----+-----+-----+-----+
| year | salary | FTP | STP | PYSR | RTIWD | AMTTI | RTA | AMT |  AMTR   | FTL | FTR | STR | MIB |
+------+--------+-----+-----+------+-------+-------+-----+-----+---------+-----+-----+-----+-----+
|    1 | 100K   | 30K | 13K | 0    | 87K   | 100K  | 29K | 30K | RTA<AMT | 30K | 0   | 3K  | 60K |
|    2 | 100K   | 30K | 10K | 3K   | 93K   | 103K  | 31K | 31K | RTA>AMT | 31K | 1K  | 0   | 59K |
|    3 | 100K   | 30K | 10K | 0    | 90K   | 100K  | 30K | 30K | RTA=AMT | 30K | 0   | 0   | 60K |
+------+--------+-----+-----+------+-------+-------+-----+-----+---------+-----+-----+-----+-----+

Now comes the previous year AMT recalculation to see the portion of the state refund that is actually taxable. When you do said recalculation as turbotax explains you simply end up doing the calculation with the state tax payments (deduction) being 10K and we know that the federal tax liability in that case is 30K. In other words his tax liability didn't change, so according to turbotax all his state refund is taxable. . Bottom line, if you overpay your state taxes, IRS might penalize you through AMT in the current year and won't correct it in the next year (according to turbotax calculation).

So, is this true? Does the IRS actually penalize you in this way if you either overpay or underpay your state taxes? To me it seems absurd that you'd be penalize for overpaying taxes.

5

There are a couple of issues here:

  1. In case of underpayment of the State tax, the extra you need to pay is deductible in the following year.

  2. In case of overpayment, you got 1K AMT credit, which you can use.

The assumption that the marginal rate equals exactly the AMT rate for such low amounts is unreasonable, and very small percentage of people pay AMT year after year, and have it exactly equal to their "regular" liability. For most, AMT is either a one-off occurrence (typically due to ISO vesting), or a permanent thing with AMT being well above the standard tax.

For the first group of people the AMT credit balances the issue the next year you're above the AMT with the regular tax, for the second group State taxes were never deductible (as there would be no point in itemizing) and as such - not taxable.

Generally, you only include the refund as income to the extent that prior year deduction provided tax benefit. That is what the Turbo Tax instructions are trying to accomplish. However, Turbo Tax is not intended for people who always have AMT, and as such - they simplified the instructions for their target audience.

If you want the full thing - read the IRS Publication 525.

0

Are you sure that "tax liability didn't change, so according to turbotax all his state refund is taxable"? I don't use Turbo Tax but from what I understand, if your tax liability for the previous year doesn't change after recomputation, then none of your state tax refund is taxable this year. Essentially, you didn't get any benefit from "itemizing" the "extra" state tax last year, hence you don't owe any additional taxes this year. This should cover the overpayment situation you outlined above.

The underpayment situation is interesting. While the example above is contrived and may not resemble a real life situation (ie. Regular and AMT tax being same year after year), if it really happens, it does look like you'll be $1k out of pocket more than you'd have been if you had paid the state tax on time. This would happen because one year you owed more on regular taxes and the next year you'd owe more on AMT. But again, a situation like this is rare.

Side note: I don't think the extra AMT paid in these examples can be used as credit in the next years. As I only learnt recently, the AMT that gets triggered due to state taxes doesn't carry forward as credit. Only the part of AMT that gets triggered due to deferral items such as ISOs carries as credit for next years.

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