If you're itemizing your deductions, you get to deduct either your state and local income taxes or state and local sales taxes. The deduction for state income tax is figured based on the amount you actually paid during the year -- not how much your final bill comes out to be when you file your return.
Includable Taxes Paid
You're only allowed to include the taxes that you actually paid out of pocket during the year. These include both state income tax withholding, such as the amounts your employer withholds from your paycheck for state income taxes, and any estimated state income tax payments you make during the year. Any tax payments you make during the following calendar year, such as sending in a check with your state income tax return, don't count toward your deduction for the prior year. For example, say you had $5,000 withheld for state income taxes from your paycheck during 2013 and when you file your return in April 2014 you pay another $500. You're limited to deducting $5,000 on your 2013 taxes.
Effect of Liability
Your prior year's tax return also affects how much you get to claim as part of your state and local income tax deduction. If you had a liability, it adds to your taxes paid during the year -- assuming of course that you paid your bill. For example, say you had $5,000 withheld from your paychecks for state taxes during 2013. If, when you filed your 2012 return in April 2013, you paid $500 in state taxes, your deduction goes up to $5,500.
The deduction for state and local income taxes goes on line 5a of Schedule A. Check the box next to line 5a to indicate you're deducting income taxes rather than sales taxes, because you're not allowed to claim both in the same year. Of course, if your total itemized deductions don't surpass your standard deduction, the whole discussion is a moot point because you're better off claiming the standard deduction instead.
Don't go overpaying your taxes just to get a bigger deduction. The amount of any refund you get doesn't decrease your deduction, but you still have to include it in your income for the year on line 10 of Form 1040. For example, say you claimed a deduction for state and local income taxes on your 2012 tax return and received a $1,000 state tax refund. On your 2013 federal taxes, you have to include that $1,000 as taxable income. However, if you didn't claim a deduction for state and local income taxes the prior year, either because you didn't itemize or you claimed state and local sales taxes instead, you don't have to include the refund as taxable income.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."