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July 13, 2020
For tax rates, some states have a single rate for all income while others use marginal rates in the same way as the federal government.(GETTY IMAGES)
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.
"Thirty years ago, (many) deductions and credits did not filter down to the state and local level," says Jeff Warnkin, a certified public accountant and certified financial planner with The JL Smith Group, a tax and retirement planning firm in Avon, Ohio.
However, jurisdictions offer more options for savings today. 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 taxes in the future.
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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 2020, a single taxpayer will pay 10% income tax on up to $9,875 in earnings. Then, income from $9,876 to $40,125 will be taxed at 12% while earnings of $40,126 to $85,525 will be subject to a 22% tax. The income tax rate brackets max out at earnings of $518,401 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, including a standard deduction of $12,400 for single taxpayers and $24,800 for married couples filing jointly for 2020, people pay taxes on less income than what they actually earn.
At the state level, taxes are usually calculated differently. "Each state income tax is a different animal," says Michael Corrente, managing director in the tax group of accounting firm CBIZ & MHM New England. While some states base their taxes on a person's federal adjusted gross income, others make adjustments with their own deductions and credits. What's more, some states will exclude certain types of income, such as Social Security or government pensions, from their tax calculations.
As for tax rates, some states have a single rate for all income while others use marginal rates in the same way as the federal government. State tax rates commonly fall between 2% to 13%, according to Warnkin. A handful of states, such as Florida, Nevada and Texas, don't charge a state income tax.
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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.
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.
"They get you on all the different licensing fees and utility fees," Warnkin says. Residents in areas without income tax may also pay more in property or sales tax. Another trade-off to living in a low-tax area may be reduced government services.
"It's so unique in every state," Corrente says. 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.
Head of Tax Department