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SHOULD YOU PREPAY YOUR STATE AND LOCAL TAXES?

December 16, 2007

Paying your state and local taxes early is one of the oldest tricks in the year-end tax planning book. If you are going to owe the state in April, you might as well take the deduction now, right?

Maybe.

While prepaying taxes might seem like a simple "yes or no" question, it's not necessarily so. You need to consider several factors:

Are you going to be itemizing deductions for 2007? If not, then there's no point in paying early.

Are you going to be paying alternative minimum tax for 2007? The itemized deduction for state and local taxes doesn't apply in computing AMT, so you might be wasting your time getting your taxes paid early - and if you won't be in AMT in 2008, you might be squandering a deduction if you do pay early.

Is it worth giving up the interest the payment would earn to get that deduction in April? The chart below shows whether prepaying makes sense for a taxpayer who is not in AMT for either 2007 or 2008, at different tax brackets, and who won't have penalties for underpayment of estimated tax whether or not taxes are prepaid. The dates shown are typical deadlines for state and local tax payments (detail below the fold). It shows that it always makes sense for a non-AMT taxpayer to prepay a 4th quarter state payment, but only high-bracket taxpayers benefit from prepaying you state taxes due next April.

prepaychart.JPG

But this chart only works if you meet all of the simplifying assumptions. If you are basing your estimated taxes on your actual 2007 income, rather than, say, your 2006 taxes, a state tax payment now might wipe out a federal tax underpayment penalty due from the first, second and third quarters - which obviously changes the math. And if you are in a low bracket this year, but next year you have a windfall coming, it's likely the deduction will be worth more to you next year. And vice-versa.

In any case, you need to start by running the numbers.

This is another of a daily series of 2007 year-end tax planning posts running through December 31. Add to your collection!

Dates used in the chart above:

January 31: due date of Iowa fourth quarter estimated taxes.
March 1: due date of first Iowa property tax installment.
April 15: due date of most state individual tax returns.
April 30: due date of Iowa individual tax returns.
September 1: due date of second Iowa property tax installment.

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