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How can our state tax refund be taxable again?

Actually, you were never taxed on this refund. If you itemize correctly you would have deducted the total amount of withheld state taxes from FY 2000 from you FY 2000 Federal Tax return. Since you received a state tax refund the amount of your state tax deduction was too large. Therefore you must claim the difference as income for the next fiscal year. This works in reverse as well; if you owed state taxes for FY 2000 that were paid in FY 2001 you could add them to this year's state tax withholding.

This concept makes for an interesting way to move income from one tax year to another.. IE, if you expect your tax rate to drop significantly next year, you may want to withhold extra state taxes this year. I'm not sure about the legality of this...

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