There are a few rare situations where you may be forced to repay income from a prior year. Some examples of this may include Social Security benefits repayments, overpaid vacation or sick pay from an employer, overpaid unemployment benefits, and potentially many other situations could apply.
The IRS and many states allow you to claim a credit for the difference in tax that you would have paid if the repaid income had not been reported on the prior year tax return and the tax you actually paid on the prior year tax return.
Follow these steps to calculate the credit:
- Have a copy of the return for the year in which the repaid income was reported as taxable income.
- Verify that the repaid income was taxable income for that year. For example, if you had to repay social security benefits, the benefits may not have been taxable income on that return. Pandemic Unemployment benefits also may not have been taxable.
- Recreate the original return with the exception that you are excluding the repaid income by setting up a dummy account in FreeTaxUSA (a dummy account is a return you will never file that is used for calculation purposes only). For example, if the repaid income was Social Security benefits, reduce the amount you enter as Social Security benefits by subtracting the repaid portion.
- Find the difference in the Total Tax between the original return and the dummy return, by subtracting the amount of Total Tax (2022 and 2023 Form 1040, Line 24) of the original return from the Total Tax of the recreated dummy account return that excludes the recreated income.
- In the current year return, follow this menu path: Deductions/Credits > Claim of Right Repayment Credit. Answer Yes to the question about whether you repaid income > enter the difference in prior year tax between the original return and recreated return that excluded the repaid income.
Make sure you keep records of the repayment requirement (letters, emails, bills from the payer who required the income repayment) proof of repayment (canceled checks, money orders, paycheck deductions, or bank statements) and documentation for how you recalculated the repayment (the original return, the recreated return with the excluded income). This credit is often calculated incorrectly by taxpayers, so be prepared to respond to potential IRS documentation requests.
