When it comes to talking about taxes, federal income tax gets the lion’s share of the attention. However, it is far from the only money paid by U.S. residents to the government. Most states have income taxes, and nearly 5,000 taxing jurisdictions across 17 states have local income taxes as well, according to the Tax Foundation, an independent nonprofit that conducts tax policy research.
Across state and local jurisdictions, there is a wide variety of tax systems in use. “Every locality is so different,” says Holly Gyles, vice president of tax policy and research for Goldman Sachs Ayco Personal Financial Management. “We talk to our clients all the time about these state taxation issues.”
Those issues include differences in what income is taxed and how money is collected from residents and non-residents. Some states may only tax certain types of income, have their own income deductions or maintain other provisions unique to their jurisdiction.
That means taxpayers should take the time to understand how the various levels of taxes work and use that information to help them look for ways to lower their overall tax bill.
Federal Income Tax: A Progressive System
The federal government uses a progressive tax system, also known as a graduated income tax. Its current tax brackets range from 10% to 37%, and these are marginal tax rates. That means different rates may be applied to different portions of a person’s income.
This can be confusing for some people who believe the common myth that a person’s tax bracket dictates their tax rate. “They think they are paying that rate on all their income,” says Gary Bingel, partner-in-charge of the national state and local tax group with financial firm EisnerAmper.
Instead, people pay less than their tax bracket would imply. For instance, in 2022, a single taxpayer with an annual income of $50,000 will pay 10% income tax on the first $10,275 in earnings. Then, income from $10,276 to $41,775 will be taxed at 12% while earnings of $41,776 to $50,000 will be subject to a 22% tax.
The income tax rate brackets continue to increase until they max out at earnings of $539,900 for a single taxpayer. At that point, any income in excess of that amount is taxed at 37%.
Marginal rates mean a taxpayer will pay an effective tax rate that is lower than their top bracket. In 2019, the latest year for which data is available, the average individual income tax rate was 13.29%, according to the Tax Foundation, with the top 1% of taxpayers paying 25.6% and the bottom 50% paying an average rate of 3.5%.
Since the federal government offers a number of deductions, people pay taxes on less income than what they actually earn. For example, for 2022, the standard deduction is $12,950 for single taxpayers and $25,900 for married couples filing jointly.
State Income Tax Laws Vary
At the state level, taxes may be calculated differently. Thirty-two states and the District of Columbia have graduated income taxes similar to the federal system, nine assess a flat income tax and seven have no income tax at all, according to the Tax Foundation. Two states — New Hampshire and Washington — have systems that only tax certain income, such as dividends or capital gains, and New Hampshire, for example, has plans to phase those taxes out completely.
[READ:9 States With No Income Tax]
While some states base their taxes on a person’s federal adjusted gross income, others make adjustments by offering their own deductions and credits. For example, while the Tax Cuts and Jobs Act of 2017 eliminated the ability to deduct unreimbursed employee expenses on federal income tax forms, a handful of states, such as California, continue to offer this deduction on their state income tax forms.
States may also differ from the federal government in terms of what they consider taxable income. “Some states don’t tax retirement income,” says Lisa Featherngill, national director of wealth planning for Comerica Bank. That means people in those states may not pay tax on Social Security or government pensions.
As for tax rates, states with flat tax systems typically have rates in the range of 3% to 5%. Meanwhile, California has the highest marginal state tax rate in the country. The state has 10 tax brackets for 2022, starting with a 1% bracket for income up to $9,325 and ending with a 13.3% tax rate for income in excess of $1 million for single filers. North Dakota is on the other end of the spectrum with five tax brackets that start at 1.1% for income up to $40,525 and tops out at 2.9% for income in excess of $445,000.
Federal vs State Tax: What Are the Key Differences?
The difference between state and federal taxes can be summed up in this way:
— Federal tax rates are typically higher than state tax rates.
— States can have different credits and deductions.
“States also tax people whether they are a resident or nonresident,” Gyles says. For those who earn income in multiple states, that means filing multiple state returns each year.
Since many states use the federal AGI as a starting point for their calculations, taxpayers get the benefit of some federal tax deductions when filing their state tax forms. These include deductions for contributions to qualified retirement funds and health savings accounts, both of which are deducted from income when determining a person’s federal AGI.
Then, states may make adjustments to the federal AGI with their own credits, deductions or add backs, which are items that are deducted on federal returns but taxable by a state. For instance, while some state and local taxes may be deductible on federal returns, states may require them to be added back for purposes of calculating state income taxes.
Federal Withholding Tax vs. State Withholding Tax
Since state and federal taxes vary, your withholdings for each will likely be different. While employers will often calculate tax withholdings for workers, you may also want to check the amounts yourself.
The IRS maintains an online tax withholding estimator that can be used to ensure the proper amount is being withheld from paychecks. States may have their own calculators or withholding tables to make these calculations as well.
Local income tax may be assessed by cities, counties, school districts or other municipalities. “They are less common,” Featherngill says, “(but) they are just like a state income tax.”
States in the Midwest and Great Lakes region are most likely to have local income taxes with the majority of taxing municipalities being located in Ohio and Pennsylvania. Jurisdictions typically charge a single tax rate that often falls between 0.5% to 3%.
They also may have both resident and nonresident taxes. Nonresidents pay local income tax only on money earned in that municipality while residents pay taxes on all income, regardless of where it is earned. Residents who work in a different municipality that charges an income tax may receive a credit for those tax payments, Bingel says.
Should You Move to Save Money on Taxes?
Although overshadowed by federal credits and deductions, state tax incentives exist for both corporations and individuals. These may include state earned income tax credits, homestead property tax credits and deductions for college savings or long-term care insurance premiums.
With many workers now in a position to work remotely, it may be tempting to move somewhere that has a lower tax rate, but Featherngill advises people to consider the overall tax burden of an area, not just its income tax. “Some of the states without an income tax do have significant property and sales tax,” she says.
States and local units of government need revenue to pay for services such as roads, police and fire protection. If money is not coming in from income taxes, municipalities have to get it elsewhere. Residents in areas without income tax may pay more in property or sales tax. Another trade-off to living in a low-tax area may be reduced government services.
What’s more, if you are still earning income in another state, you could still pay that location’s income tax even if you live elsewhere. “Sometimes people can move and not pay any income tax, but that’s not always the case,” according to Gyles.
Each state also has its own requirements for residency. Buying a second home in another state and changing your driver’s license address may not be enough to change your domicile for tax reasons. “You’re going to have to sell your house, give up your country club membership and cut ties,” Bingel says. “(People) don’t realize all the hoops you have to go through.”
Some states, like New York, have implemented programs to ensure people, particularly high earners, aren’t evading state income taxes by claiming to live in another state where they actually aren’t full-time residents.
Given these considerations, if you want to lower your state and local taxes, talk to a tax professional who can help you understand the pros and cons of moving or how to maximize savings in your current location.
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Update 04/12/22: This story was published at an earlier date and has been updated with new information.