If you qualify to exclude the income from federal taxes under the 2014-7 Difficulty of Care Act, the amount in box 1 of your Form W-2 is exempt from federal tax. However, the number from box 1 is also used to calculate Earned Income Credits and other tax situations that look at earned income. If you have the number from boxes 3 and 5 also entered in box 1, the calculations in those areas will be correct.
This TurboTax Help article explains how to leave the number in box 1 but also remove it from the calculation for taxable income. There are related links at the bottom of the article for more information about IRS Notice 2014-7. If you enter it in this way in the federal return, it will be treated correctly when the income flows to the state return.
How to enter excluded Medicaid waiver payments in TurboTax
There is more information about the exclusion of Medicaid waiver payments at this IRS website Medicaid Waiver Payments
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