Iowa taxes people on their federal tax refunds received. And yes, they do audit this.
I have helped
3 4* people in the last 6 weeks who received a notice from the Iowa Department of Revenue regarding their 2011 Iowa tax return. In all 3 4 cases, the taxpayer had used TurboTax to prepare their 2011 tax return. In all 3 4 cases, TurboTax didn’t account for the taxpayer’s 2010 federal tax refund on the 2011 Iowa return. In all 3 4 cases, the Iowa Department of Revenue caught the omission and assessed additional taxes, interest and penalties against the taxpayers. In all 3 4 cases, I had to be the bad guy and say “sorry, but the state is right …. You owe.”
(*-It’s now 4 people, as another client brought me another one of these notices within hours of this blog post first appearing.)
As a reminder, Iowa makes you claim your prior-year refund as taxable income on your current-year Iowa return. So for 2013, you’ll claim your 2012 federal refund as income.
Depending on your federal tax situation, not all of your refund will be taxable. Basically any refund attributed to excess withholding is taxable, but refunds resulting from refundable credits such as the Earned Income Credit are not taxable.
I wrote extensively about this topic two years ago in this post.