Federal income tax often dominates discussions around taxation, but it’s just one part of the broader tax landscape in the United States. In addition to federal taxes, most states and numerous localities also impose their own income taxes. In fact, there are close to 5,000 local taxing entities across 17 states, as reported by the Tax Foundation, a reputable independent organization dedicated to tax policy research.
The tax systems across these jurisdictions vary significantly. “Each locality has its unique elements,” explains Holly Gyles, vice president of tax policy and research at Goldman Sachs Ayco Personal Financial Management. She notes that they frequently discuss these state tax nuances with their clients.
The complexities of these tax systems mean that the types of income subject to taxation, as well as the deductions and other special rules, can differ markedly from one state to another, and even more so across local jurisdictions. This complexity underscores the importance for taxpayers to invest time in understanding the different tax layers and leverage this knowledge to potentially reduce their total tax liability.
Understanding the Federal Income Tax System: How It Works
The U.S. government employs a progressive, or graduated, income tax system, with current tax brackets ranging from 10% to 37%. These are marginal tax rates, meaning different portions of an individual’s income are taxed at varying rates.
A common misunderstanding is that a person’s tax bracket determines the rate applied to their entire income. Gary Bingel, partner-in-charge at EisnerAmper’s national state and local tax group, clarifies, “Many believe they are taxed at a consistent rate across all their income.”
However, the actual tax situation is more favorable. For example, in 2022, a single taxpayer earning $50,000 annually will owe 10% on the first $10,275, 12% on income between $10,276 and $41,775, and 22% on the remainder up to $50,000.
Tax brackets escalate to a peak at incomes over $539,900 for single filers, where earnings above this threshold are taxed at 37%. Despite these high marginal rates, the effective tax rate—what one actually pays—is typically lower. For instance, in 2019, the average individual tax rate was just 13.29%, with the top 1% paying 25.6% and the bottom 50% paying only 3.5%, reports the Tax Foundation.
The federal tax system also offers numerous deductions, reducing taxable income. In 2022, standard deductions are set at $12,950 for single filers and $25,900 for married couples filing jointly. This structure ensures that individuals pay taxes on a reduced base of their total earnings, further decreasing the effective tax rate.
Understanding the Diversity of State Income Tax Laws
Income tax laws at the state level exhibit significant variation. According to the Tax Foundation, thirty-two states plus the District of Columbia use a progressive tax system similar to the federal structure. Meanwhile, nine states apply a flat tax rate, and seven states levy no income tax whatsoever. Unique systems exist in states like New Hampshire and Washington, which tax specific types of income such as dividends or capital gains. Notably, New Hampshire is moving towards eliminating these taxes entirely.
Tax bases and deductions also differ significantly across states. While federal tax reforms such as the Tax Cuts and Jobs Act of 2017 have eliminated certain deductions like unreimbursed employee expenses, states like California still allow these deductions on their tax forms. Moreover, some states do not tax retirement income at all, which can include Social Security or government pensions, according to Lisa Featherngill, Comerica Bank’s national director of wealth planning.
Tax rates vary too, especially between states with flat and progressive tax systems. States with flat taxes generally have rates ranging from 3% to 5%. On the higher end, California’s progressive tax system includes ten brackets, with rates escalating to 13.3% for incomes over $1 million. In contrast, North Dakota’s system features lower rates, with a maximum of 2.9% for incomes above $445,000. This diversity in tax structures reflects the broad range of fiscal policies across the United States, impacting residents in markedly different ways.
Federal vs. State Taxes: Unpacking the Differences
Understanding the distinctions between federal and state taxes is crucial. Here’s a streamlined explanation:
- Tax Rates: Generally, federal tax rates are higher compared to those set by states.
- Credits and Deductions: Each state offers unique credits and deductions.
- Residency and Tax Obligations: According to Gyles, whether someone is a resident or a nonresident, states will tax them. This implies that individuals earning income across various states need to file multiple state tax returns annually.
- Utilizing Federal Adjusted Gross Income (AGI): Many states calculate their taxes starting with the federal AGI. This benefits taxpayers by allowing them to carry over certain federal deductions into their state filings. Notable deductions include those for contributions to qualified retirement plans and health savings accounts, which reduce the federal AGI.
Furthermore, states might adjust the federal AGI with their specific credits, deductions, or add-backs. These are items deducted on federal returns but might be taxable at the state level. For example, while some state and local taxes are deductible on federal returns, states might require these to be added back when calculating state taxes.
Differences Between Federal and State Withholding Taxes
The nuances between state and federal withholding taxes mean that the amounts deducted from your paycheck may differ. Employers typically handle these calculations, but it’s wise to verify the amounts independently.
For federal taxes, the IRS offers an online tax withholding estimator, allowing you to check if the correct amount is being withheld from your salary. Similarly, many states provide their own tools, such as calculators or withholding tables, to help you determine the appropriate withholdings.
Local Income Taxes: Understanding Regional Variations
Local income taxes are levied by various entities such as cities, counties, school districts, or other local governments. According to tax expert Featherngill, these taxes are relatively rare but function similarly to state income taxes.
The regions most commonly associated with local income taxes are the Midwest and Great Lakes areas, with a significant number of these taxing jurisdictions found in Ohio and Pennsylvania. Typically, these localities impose a uniform tax rate that generally ranges from 0.5% to 3%.
Local income taxes often apply differently to residents and nonresidents. Nonresidents are required to pay taxes only on income earned within that specific municipality, whereas residents are taxed on their entire income, irrespective of the location it was earned. For residents who work in a different taxing municipality, there is often a provision to receive a credit for tax paid to other municipalities, as noted by tax professional Bingel.
Is Relocating to Cut Taxes a Smart Move?
State tax benefits, often eclipsed by federal incentives, are available for both companies and individuals. These perks may include state-specific earned income tax credits, property tax credits for homeowners, and deductions linked to college savings or premiums for long-term care insurance.
The rise of remote work offers the flexibility to move to areas with lower tax rates. However, Featherngill suggests weighing the entire tax load of a region, rather than just the income tax component. “States lacking income tax might compensate with hefty property and sales taxes,” she notes.
Local governments rely on revenue to fund essential services like road maintenance, and emergency services. In places without income tax, revenue might be raised through higher property or sales taxes instead. Moreover, residing in a low-tax jurisdiction might mean fewer public services.
Additionally, earning income in one state while living in another doesn’t necessarily free you from the former’s income tax obligations. “It’s possible to relocate and escape income tax, but it’s not guaranteed,” Gyles points out.
Establishing residency in a new state involves more than just buying property or updating your driver’s license. As Bingel explains, “You’ll need to sell your existing home, terminate local memberships, and sever ties. Many aren’t aware of the extensive steps involved.”
Some states, such as New York, have initiated measures to prevent especially affluent residents from dodging state taxes by falsely claiming residency in a tax-favorable state.
Considering these factors, consulting with a tax expert is advisable if you’re exploring ways to reduce your state and local tax liabilities. They can provide insights into the benefits and drawbacks of relocating, or how to optimize your tax situation without moving.
Recent Comments