I think I discovered a flaw/inconsistency in how state income tax refunds are handled by the IRS. If you itemize deductions, then state income taxes reduce your taxable income for filing year (e.g. 2025). But if you get a state income tax refund the following year (e.g. 2026) then the refund amount is added to your AGI, not your taxable income (subject to the limitation of how much the state income tax deduction increased your itemized deduction total compared to the standard deduction in 2025).
If the refund was just added to your taxable income that would be fair. But adding to AGI is not the same as adding to taxable income, as it can have some additional adverse effects on how much taxes you pay. For example, it can increase how much your Medicare premiums will be in subsequent years (2027 and beyond). Also, a higher AGI can increase your NIIT surcharge in 2026 (if you're subject to that). [There may be other adverse tax consequences of a higher AGI compared to just a higher taxable income; I'm not a tax expert but I do know that a higher AGI is never good.]
TurboTax seems to be unaware of these other possible adverse tax consequences of a higher AGI compared to just a higher taxable income. It seems like as soon as your itemized deductions total more than the standard deduction, TT recommends you take the former. And when it's listing possible reasons why you might not want to do that, though it mentions that your state refund will be taxable, it doesn't mention the fact that a higher AGI in 2026 and beyond can result in a tax impact that actually makes you end up paying more taxes in total over 2025/6/7.
To summarize: if your state tax refund were only added to your taxable income in 2026 (and since that increase is limited to how much the state tax deduction reduced your taxable income for 2025), it would in essence be a wash, so one might argue to take the additional deduction to get a bigger refund now, and then even if you have to pay a comparable amount more in fed tax next year, you had the additional fed refund money for a year. But as soon as you're subject to more payouts (e.g. NIIT, Medicare premiums) in subsequent years that make it worse than just a wash, you can easily end up worse off.
Suggestion for TT: after TT calculates your Fed and state returns (before you file), if your state tax refund for 2025 (that you'll receive in 2026) is equal to or greater than how much itemizing your state income tax reduced your taxable income for 2025, it should alert you that the benefit of itemizing deductions in 2025 will not only be washed out by the increase in AGI in 2026, but you may actually come out worse than if you took standard deduction (due to AGI increasing NIIT, Medicare premiums and who knows what else).
Again, this mess wouldn't exist if the IRS rule was that your state tax refund got added to just your taxable income, not your AGI. If you reduce your taxable income by amount X in year 2025, then you shouldn't be adding back X to your AGI in the next year.
(Btw, the above discussion doesn't even include the consideration that itemizing deductions makes your recordkeeping and returns more complicated than standard deduction, so if there is very little to perhaps zero gain over the 2+ year period, it's a very dubious strategy.)
Ques 1: Does anyone know a rationale why state tax refunds are added to AGI instead of taxable income, where the deduction was applied to in the first place?
Ques 2: Am I missing anything here which would make itemizing better than standard deduction if your state tax refund in 2026 is equal to or greater than the state tax deduction benefit in 2025?
Ques 3 for TT experts: Do you agree TT should at least mention this caveat when it's recommending you take itemized deductions?
