The State Income Tax Deduction
Deducting state and local income taxes on Schedule A
Obvious advantages stem from being able to deduct the full cost of state and local taxes you have to pay every year. Who wants to pay taxes on more income than he has to? Less obvious are a few strategies that professionals use to mitigate the tax liability you may have from one year to the next.
Eligible Expenses for the State Income Tax Deduction
All income taxes that are imposed by a state, local or foreign jurisdictions can be deducted subject to a few rules. First, you must itemize your deductions on Schedule A to claim them. This means foregoing the standard deduction, which is often more than the total of a taxpayer's itemized deductions for the tax year. Don't be penny wise and pound foolish and give the Internal Revenue Service more money than you have to. Make sure your total itemized deductions exceed the standard deduction for your filing status so itemizing is worth your while.
The tax must also be imposed on you personally. You can't claim a deduction for income taxes one of your dependents – and in some cases, your spouse – might have paid. You must have paid them during the tax year for which you're filing.
Eligible expenses that can be deducted as state and local income taxes include:
- Withholding for state and local income taxes as shown on Form W-2 or Form 1099
- Estimated tax payments paid during the year
- Extension tax payments paid during the year
- Payments made during the year for taxes that arose in a previous year
- Mandatory contributions to state benefit funds
Documents You'll Need to Support Your Deduction
Payments of state and local income taxes can show up on a variety of different documents. If you pay estimated taxes to your state or municipality, keep copies of your checks or your bank statements showing the debits from your account. State taxes can also show up on various documents related to tax withholding. Keeping a record of all this paperwork will help you maintain a tally of how much you can deduct. Here's a short list of documents that should show how much state or local tax you paid during the year:
- Form W-2 (Wage and Tax Statement), which shows state income tax withholding in box 17. Local income tax withholding is shown in box 19 and contributions to state benefit funds may be shown in either box 19 or in box 14.
- Form W-2G (Certain Gambling Winnings), which may show state income tax withholding in box 15 and local income tax withholding in box 17.
- Form 1099-G (Certain Government Payments), which may show state income tax withholding in box 11.
- Form 1099-INT (Interest Income), which may show state income tax withholding in box 13.
- Form 1099-DIV (Dividends and Distributions), which may show state income tax withholding in box 14.
- Form 1099-R (Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.), which may show state income tax withholding in box 12 and local income tax withholding in box 15.
- Form 1099-MISC (Miscellaneous Income), which may show state income tax withholding in box 16.
- Bank statements with copies of canceled checks or debits for estimated payments and after-the-fact payments of state tax.
- The portion of the previous year's state refund that was applied toward estimated taxes.
Year-End Tax Planning Using the State Income Tax Deduction
The state income tax deduction is useful in year-end tax planning because taxpayers can elect to increase their state tax payments at the eleventh hour to cover any expected state liability that will occur for the year. For example, you can pay your fourth state estimated tax payment, normally due on January 15, in December. This would boost your itemized deductions and can potentially reduce your federal tax liability for the year.
Check to see if increasing state tax payments at the end of the year will impact your federal return – taxpayers who are impacted by the alternative minimum tax likely will find that they receive little or no benefit on their federal return by accelerating state payments.
The State Income Tax Deduction Is an Adjustment Item for the AMT
The deduction for state and local income taxes is an adjustment item when you're calculating the alternative minimum tax or AMT. This means that state and local income taxes are deductible when you're calculating your regular federal income tax, but they're not deductible when you're calculating the AMT. Taxpayers who have AMT liabilities generally receive little or no benefit from deducting state and local income taxes because these deductions are added back to their taxable income.
You might consider deducting sales tax instead of the state income tax as an alternative strategy – it's an either/or option. You can claim income taxes or sales taxes, but not both. This generally won't change your federal tax liability because the sales tax deduction is also eliminated for purposes of calculating the AMT, but at least deducting the sales tax can make any state tax refunds non-taxable the following year.
Special Rules for Spouses
Married taxpayers who are filing jointly can deduct all state and local income taxes that each of them paid during the year regardless of whether those tax payments were made separately or jointly. However, married taxpayers who file separate returns can only deduct state and local income taxes paid by them personally. "If you and your spouse file separate state, local and federal income tax returns, you each can deduct on your federal return only the amount of your own state and local income tax that you paid during the tax year." (Publication 17, chapter 22, section on state and local income taxes)
Additionally, married couples who file joint state but separate federal returns are subject to special rules regarding how they can deduct the state income taxes they paid for the year. In most cases, each spouse can only deduct the amount of state taxes paid that is proportionate to the percentage of income they generated on an individual basis as compared to the joint total. In some cases, deducting the actual amount of individually paid state taxes can be more advantageous than just taking a deduction that's a percentage of how much you earned of the total amount of joint income.
Each spouse can deduct the amount of state and local taxes he or she actually paid during the year only if they live in a state that declares them jointly and individually liable for their state and local tax payments.