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. “There are some states that have a flat tax, and there are some that have no tax at all,” says Tim Speiss, co-chair of the personal wealth advisors practice for accounting firm EisnerAmper LLP. Beyond that, 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.
For instance, in 2021, a single taxpayer with an annual income of $50,000 will pay 10% income tax on the first $9,950 in earnings. Then, income from $9,951 to $40,525 will be taxed at 12% while earnings of $40,526 to $50,000 will be subject to a 22% tax.
“It’s not the full $50,000 (taxed) at 22%,” says Lisa Greene-Lewis, certified public accountant and tax expert for TurboTax, and a U.S. News contributor. The marginal rates mean a taxpayer will pay an effective tax rate that is lower than their top bracket.
The income tax rate brackets continue to increase until they max out at earnings of $523,600 for a single taxpayer. At that point, any income in excess of that amount is taxed at 37%.
Since the federal government offers a number of deductions, people pay taxes on less income than what they actually earn. For example, for 2021, the standard deduction is $12,550 for single taxpayers and $25,100 for married couples filing jointly.
State Income Tax Laws Vary
At the state level, taxes may be calculated differently. Thirty-two states have graduated income taxes similar to the federal system, 10 assess a flat income tax and nine have no income tax at all, according to the Tax Foundation.
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, Greene-Lewis says a handful of states, such as California, continue to offer this deduction on their state income tax forms.
Some states will also exclude certain types of income, such as Social Security or government pensions, from their tax calculations. New Hampshire is unique in that its flat tax only applies to what Speiss describes as “portfolio income” such as dividends and interest.
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 2021, starting with a 1% bracket for income up to $8,932 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 $40,125 and tops out at 2.9% for income in excess of $440,600.
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.
“Most states piggyback off the federal calculations,” Speiss says, “(but) some states have their own definition of (adjusted gross income).”
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.
“If you work in two states, you’ll have to file two tax returns,” Greene-Lewis says. Don’t forget to check the withholding rates in each jurisdiction.
Local income tax may be assessed by cities, counties, school districts or other municipalities. However, “Those local taxes are pretty few and far between,” says Clarence Kehoe, a CPA and head of the tax department at accounting firm Anchin Block & Anchin in New York City.
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 1% to 3%.
“The cities will oftentimes tax everything you get except Social Security,” says Paul Joseph, a CPA and co-owner of financial firm Joseph & Joseph Tax and Payroll in Williamston, Michigan.
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.
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.
“Those credits might not exist in the state next door,” Kehoe says. For that reason, deciding whether to change residency can be an important part of retirement planning or job relocation decisions.
Be aware, though, that each state 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. 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.
Also, keep in mind that 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.
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.