If you live in a state that taxes your investment income, such as your interest earnings and the stock dividends, you are eligible to claim a deduction for that on your federal tax return. However, before you calculate the amount of state taxes to deduct, make sure it's beneficial for you to itemize deductions.
1. Estimate the total of your itemized deductions. Because you can claim a state income tax deduction only on Schedule A, you must evaluate which method -- standard deduction or itemizing -- would save you more in federal income tax. Estimate your total itemized deduction so you can compare it to the standard deduction.
2. Find the standard deduction amount for your filing status. The federal government fixes the amount of the standard deduction you can claim on your return; however, the amount is different for each filing status. The instructions to your 1040 form provide the requirements for each filing status: single, head of household, married filing jointly or separately, and qualifying widow(er) with dependent child. Once you know your filing status, find the corresponding standard deduction.
3. Compare the standard deduction to your total itemized deduction. Because the IRS allows you to choose the larger of the two deductions, you should always claim the standard deduction if it saves more on taxes than deducting your state tax payments would.
4. Calculate the total state income tax payments you make on investments. When claiming the deduction for state income taxes, the IRS allows you to include only amounts you actually pay during the tax year. If you accrue a state income tax liability only on your investment income but will not pay it until the following tax year, you cannot include it in your state income tax deduction for the current year.
5. Add investment tax payments to state tax withholding on your W-2. It isn’t necessary to claim a separate deduction for the state income taxes you pay on investment and employment earnings. Instead, combine the tax payments you make on your investment income with the state tax your employer withholds during the year. You can find that amount on your W-2 form.
6. Report your deduction on Schedule A. You can report the total of your state income tax payments in the “Taxes You Paid” section of Schedule A. Because the state tax you pay on investments and employment earnings is an income tax, be sure to check the appropriate box in the section.
- The IRS allows you to choose between a deduction for state income tax and state sales tax. Therefore, if you decide to deduct the state income taxes you pay on investments, you cannot also deduct your sales tax payments.
Items you will need
- Schedule A form
- W-2 forms
- Records of estimated state income tax payments
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