State Income Tax Refund can Create a 45% Tax Bracket or Higher

Published on: 11:29AM Apr 29, 2010

On of my favorite business magazines that I started reading as a teenager was Forbes.  This used to be a really great business magazine and it still fairly good, but with all the changes going on with the digital revolution, their web-site seems to be taking a higher priority than their magazine.  However, almost every issue has one or two good articles and in the most recent issue, there was an article on how getting a state income tax refund can create additional taxes.

I thought I would try to set up a real world example and see what type of tax rate we would end up with.  I set up a fictitious farmer couple with $125,000 of farm earnings, a rental loss of $25,000 and three kids under the age of 17.  In this example, their total federal income taxes was $10,244 for 2009. 

I then added in a taxable state refund of $15,000.  The farm couple probably overpaid their estimates for the year before and thought it was pretty good to get a nice size refund until they did their income tax return for this year.  The new federal tax bill for this couple went from $10,244 to $16,963.  This is an increase of $6,719 or an effective tax rate on this income of almost 45%, even though they are only in a 25% tax bracket.

The primary reasons for the increase is that they can no longer deduct as much of their passive loss and their child credit is almost cut in half.

Most farm families live in states with a state income tax.  You need to be cautious in paying this tax.  With most farmers, you usually pay both your federal and state income tax by March 1 and do not do estimates, however, in many states this might not be true.

Therefore, touch base with your tax advisor before paying any large state income tax estimates for the current year since you may get a large federal tax bill in the next year.