(READ THE NOTE AT THE END OF THIS POST REGARDING IOWA TAX REFORM.)
It’s an annual point of complaint for taxpayers in Iowa: Iowa makes you claim your federal tax refund as income on your Iowa tax return.
One client once went on a rant to me about how “that ain’t right! That right thar is double taxation!” (The client was originally from Louisiana, so you have to say it in a thick Bayou drawl for maximum effect.)
While it’s annoying, it’s not “double taxation,” and there is a logical explanation for why Iowa makes you claim federal refunds as taxable income.
Iowa Deduction for Federal Taxes Paid
If you look at the Iowa Form 1040, near the bottom of page 2, you’ll see a section for federal tax adjustments. One of the adjustments is for federal income taxes paid. Iowa allows taxpayers to deduct things such as:
- Federal income tax withheld from paychecks
- Federal estimated tax payments
- Additional taxes paid to the IRS (for example, if you owed when you filed your federal return, or if you got a love letter from the IRS saying you owed additional money to them)
This is why Iowa makes you claim your federal refund as income — the state gives you a deduction for federal taxes paid. If you get a refund, that implies that you paid in too much to the feds, and thus the excess gets “recaptured” by Iowa.
It’s also why, as we’ve discussed in prior posts on this subject, Iowa only makes you claim the portion of refund attributed to excess withholdings, not the portion attributed to refundable tax credits.
Example
Joe receives a $1,500 refund on his 2017 federal tax return, which he filed in 2018. This includes a $500 refundable credit for the American Opportunity Credit. On Joe’s 2018 Iowa tax return, he’ll include $1,000 of federal refund as income. The $500 portion of his refund attributed to the refundable credit is NOT taxed in Iowa.
This can also set up situations where a person gets a federal refund in “real life” but actually gets to take a a DEDUCTION in Iowa for additional federal taxes paid.
Let’s say Joe receives a $500 refund on his 2017 federal tax return, which he filed in 2018. This included a $1,000 refundable earned income credit. On his 2018 Iowa tax return, Joe will claim a deduction of $500 for additional federal taxes paid. How? We factor out the refundable tax credit from his federal return — doing so leaves Joe with a $500 federal tax liability, thus he gets to take a deduction on his Iowa tax return for “additional federal taxes paid” even though he actually got a refund.
********* NOTE: the “tax reform” bill passed by the Iowa legislature earlier this year eliminated, theoretically, all of this starting in 2023. That year, if certain state revenue targets are met, the deduction for federal taxes will be eliminated, thus eliminating the need for federal tax refunds to be reclaimed as income.
I use the word “theoretically” because apparently if the revenue targets are not met, then the law doesn’t change. *********