What Is the Definition of a Tax Carryforward?

...and How Does it Help Me Save for College?

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What is the definition of a tax carryforward? Simply put, a tax carryforward is an IRS or state income tax rule that allows a taxpayer to save an unused deduction, credit or loss, and use it in a later year.

With this review of the term, as well as examples, learn whether a tax carryforward applies to your financial situation.

How Tax Carryforwards Arise

Tax carryforwards are known by several names, including tax loss carryforward, net operating loss (NOL) carryforward, deduction carryforward or credit carryforward.

However, each term has the same meaning. A tax carryforward (spelled alternatively "carry forward") most often occurs when the IRS or a state's revenue department places a limit on the amount that can be deducted for certain items in any one year.

For example, if a state says that a taxpayer may deduct up to $5,000 in Section 529 plan contributions in any one year, an $8,000 contribution would only be partially deductible. In theory, $3,000 of this contribution would miss out on favorable tax treatment.

However, if the state offers a tax carryforward provision on Section 529 deductions, the $3,000 that was over the limit would be deductible in a later year, even if there were no further college savings program contributions ever made.

According to the IRS, "If your deductions for the year are more than your income for the year, you may have an NOL." However, there are limitations on what you may deduct when determining whether you have a net operating loss.

Any of the following are excluded when determining you losses, the IRS states:

  • Any deduction for personal exemptions.

  • Capital losses in excess of capital gains.

  • The section 1202 exclusion of the gain from the sale or exchange of qualified small business stock.

  • Nonbusiness deductions in excess of nonbusiness income.

  • The net operating loss deduction.

  • The domestic production activities deduction.

Simplifying the Term

Still confused about what a tax carryforward is? The Houston Chronicle offers a simple explanation. According to the paper, "The idea of income tax is simple: For every dollar you earn, you pay a percentage to a taxing agency. Since our success in earning income results in tax liability, it would be nice when we have a loss to expect the government to send us a payment in return."

Given this, the Chronicle explains, business owners can receive tax benefits for income losses and may receive a reimbursement. These benefits are widely known as "tax carryforwards" or "loss carryforwards."

Common Federal Carryforward Provisions

The most common federal carryforward provisions are investment losses classified as "ordinary losses" (as opposed to long-term losses) and the carryforward on charitable donations that exceed 50 percent of a taxpayer's income. Additionally, a number of the states that offer Section 529 contribution deductions also offer a carryforward provision on excess amounts. Speak to your financial advisor or contact the appropriate government agency in your state about the carryforward provisions there, or the lack thereof.

Some tax carryforwards have no time limit and may be used as long as the taxpayer is alive.

Other tax carryforwards expire after just a few years, depending on each unique carryforward rule.