TurboTax saying refund of erroneous state taxes in 2023 is taxable?!

[snoqualmie7]

Greetings everyone! I have a confusing situation (which is actually a sequel to a tricky one from last year), so I thought I'd ask for help.

So in 2022, my employer erroneously withheld taxes for the wrong state (they withheld for Maryland (office location) instead of Virginia (my home); you can read the details here).

I was able to get the erroneously withheld Maryland taxes completely refunded, which I then used to pay my Virginia state taxes (for which nothing had been withheld.)
However, now as I am working on my 2023 taxes, Turbo tax is saying that part of that Maryland tax refund ($4,972!) is taxable.

Can that be right? Seems weird that money which was refunded to me due to an error would be considered taxable. Am I (or is Turbotax) doing something wrong here? Please let me know.

Thanks in advance for any assistance on this!

—snoqualmie17

[Mike9241]

did you take an itemized deduction in 2022 for the erroneously withheld Maryland taxes? if not the refund is not taxable. if you did you got a tax benefit and now you owe the taxman.  you do get to deduct in 2023 as an itemized deduction the Virginia taxes you paid in 2023 for 2022 subject to the cap on deductible taxes on schedule A.  

[snoqualmie7]

Thanks for the reply!
Regarding itemized deductions, I'm seeing ALL of the state taxes we paid (the erroneous MD tax from my job, and the correct VA state tax from the 2 jobs my wife held) showing in box 5A on Schedule A (so I guess that the $4972 that TurboTax says is taxable is correct?).

And as for deducting the VA taxes like you mentioned, it looks like TT has already entered that under Deductions & Credits > Estimates and Other Taxes Paid > Income Taxes Paid > Other Income Taxes Paid in 2023 > Balance due on your 2022 state taxes paid in 2023.

Let me know if I should be handling any of this differently...thanks!

[ThomasM125]

When you enter in the refund in TurboTax, it will ask you some questions regarding the treatment of taxes and deductions on your prior year return. If you worked through that section and TurboTax says the refund or part of it is taxable, then it will be. You need to understand that you deducted the amount of the refund last year, so you are simply adding the deduction back this year, since the amount deducted was refunded. So you aren't paying tax on the refund, just shifting the tax you should have paid on that portion of your income from last year to this year.