The 1099-G is used by states to report your state tax refund from the prior year. Therefore, if your prior year tax return indicated that you overpaid your state taxes by $100, you should have received a 1099-G in January, indicating that the state tax refund may need to be reported on your current year’s tax return.
This is called the Tax Benefit Rule. If you receive a deduction for something and later recover it, you must put it back into income. If you itemize deductions and take all of the state payments you made during the year as a deduction and you overpaid your state tax, you have technically taken too many deductions.
In April 2012, you had to pay the state $505 in taxes when you filed your 2011 tax return. During 2012, you had state tax of $3,546 withheld from your pay. On your 2012 tax return, you would be entitled to a deduction for state taxes paid during 2012 of $4,051.
The $3,546 is shown on your 2012 state tax return as taxes withheld. However, let’s assume your tax liability for 2012 is only $3,361. The 2012 tax return that you are preparing during 2013 should show that you are due a refund of $185. If all goes well with your state filing, you should receive a check for $185 sometime during 2013. That $185 was part of the $3,546 you had withheld during 2012 and took as a deduction on your federal return in 2012. Your “real” deduction should have only been $3,361 because you overpaid by $185.
However, you simply deduct all state taxes paid and withheld during the year. Tax return preparation is complicated enough—imagine if you had to keep going back and forth to Schedule A (Itemized Deductions) on your federal form 1040 to change it every time you played with your state return. That would be a nightmare!
Therefore, if you itemized your deductions last year, received a deduction for your state income taxes paid during that year and received a refund on your state return, the refund amount listed on the 1099-G you received from the state is usually entered on Line 10 of your Form 1040 as income.
However, if you did not itemize deductions, you did not receive a tax benefit from your state tax payments. Hence, the refund is not income and is not included on your Form 1040 this year.
Of course this all could change if you are subject to the alternative minimum tax.
William G. Lako, Jr., CFP®, is a principal at Henssler Financial, and a co-host on Atlanta's longest running, most respected financial talk radio show "Money Talks" airing Sundays at 10 a.m. on Talk 920 AM, WGKA.