State income taxes

State income taxes do not always work the same way as Federal taxes. Understanding the differences specific to your state may be useful in making investment plans, and people giving advice to investors in other states need to know other state-specific issues. This page is a summary of the major differences between state and federal taxes, with links to each state's tax page. If your state is not listed on this page and you know something about the state tax, please add it.

All states
In most states with an income tax, the tax works essentially the same as the Federal tax. You compute your total income, subtract itemized deductions or a standard deduction. subtract personal exemptions (or, in some states, take a dollar credit for personal exemptions), and pay a tax based on the tax rate; the only difference is that certain items are taxed differently. States in which the tax works in a very different way (for example, no standard deduction and only limited itemized deductions, or only some types of income taxed) will be indicated below.

Interest and dividends
States cannot tax the Federal Government; therefore, interest on Government obligations, such as Treasury bonds and TIPS (but not GNMAs), is exempt from state tax. On the other hand, most states do tax obligations of other states, so income from municipal bonds from other states is exempt from Federal tax but subject to state tax. In most states, if a fund contains a mixture of taxable and tax-exempt income (for example, a bond fund holding both Treasury and corporate bonds), the tax-exempt income is not taxed by the state; some states require a minimum percentage of the fund to be tax-exempt to get any tax benefit.

Deductions
States do not allow a deduction for state income taxes; a few states do allow a deduction for Federal taxes, which effectively reduces the state tax rate.

Multiple state tax issues
States that impose a personal income tax generally require that tax be paid on all income earned in that state, as well as all income earned by residents of the state. This may result in the need to pay taxes to multiple states, but there are provisions to reduce both the tax and the paperwork burden.

Reciprocity with neighboring states
For employees who work in one state but live in another, a tax return must be filed in both states. To alleviate this double filing burden, many neighboring states have agreements not to tax salaries earned by each other's residents. This makes taxes easier to handle for commuters, as most commuters have no income earned in the other state except for salaries.

Generally, under these agreements, one state will not tax a resident of the other state on compensation that is subject to employer withholding. These agreements apply to most types of W-2 compensation earned while a resident of the reciprocal compensation agreement state. For convenience, an employer may withhold taxes at the employee's resident state tax rate.

For example, a Pennsylvania resident working in New Jersey (PA has reciprocal agreements with NJ and 4 other states) could have taxes withheld for PA at the PA rate. Only a PA state tax form is needed; no additional forms are to be filed for New Jersey unless the resident owes New Jersey tax for some other reason (for example, property sold in New Jersey).

Credit for taxes paid to another state
If you pay taxes to two states on the same income (because both consider you to be a resident, or because you are a resident of one but earned income in the other), the states allow a credit analogous to the foreign tax credit. The credit is usually the lesser of the amount you paid to the other state, or a prorated share of the tax you paid to the state where you took the credit.

For example, if you are a resident of State X with income of $100,000, of which $20,000 was taxable in State Y, and you paid $6000 in tax to State X, then you are entitled to a $1200 credit if you paid $1200 or more to State Y, and otherwise only a credit of the amount you paid to State Y.

Nonresidents and part-year residents
Nonresident tax is normally computed on a prorated basis. If you are a nonresident of state Y and have total income of $100,000, of which $20,000 is taxable in State Y, then you compute the State Y tax on the full $100,000, and 20% of the total is your State Y tax.

Some states tax part-year residents the same as non-residents, prorating full-year income. Other states do not prorate. In the example above, if you moved to State Y during the year and earned a total of $100,000, of which $20,000 was earned while you were a resident, and State Y does not prorate, then you would owe the tax on $20,000 rather than 20% of the tax on $100,000. If the tax in State Y is flat, this would not matter, but if the tax is progressive, you would owe much less tax because of the lack of proration.

Withholding
If you do not fill out a state withholding form, most states will withhold income tax using the same number of allowances as on the Federal W-4 form. This is often incorrect, either because your itemized deductions and credits are different (since state taxes are not deductible on the state form, and most Federal tax credits do not apply to the states) or because the amount a state assigns to an allowance is different (if a state has a $1000 personal exemption, then $20,000 of extra itemized deductions is 20 state allowances). Check your state withholding when you file your federal W-4 to avoid getting a large refund or a penalty.

Use tax
All states with sales taxes also impose a use tax on goods purchased out of state for use in the state by state residents; sales tax paid to another state can be taken as a credit against that tax. This tax is not part of the income tax, but in many states, there is a line on the income tax form for use tax payments to encourage compliance, and some states provide a formula for estimating the tax due if the taxpayer does not keep records.

Specific states
This section is not intended to be a comprehensive guide to the details of state taxes, just a summary of the most important issues. Go to the state web site or check with a tax advisor for details.

Specific issues for investors
This section is a summary of investment strategies which may be affected by state tax issues; see the following section for a more complete summary.


 * Any state with no income tax: Minor preference for Roth over traditional accounts (you may pay tax on traditional account withdrawals if you retire in another state). More attractive to pay down a mortgage (interest not deductible).  More attractive to invest in corporate bonds rather than Treasury bonds in a taxable account.


 * Arizona Foreign investments in a taxable account are more attractive (foreign tax credit against state as well as federal tax).


 * California Prefer Treasury bonds in a Health Savings Account (other investments are taxed).


 * Indiana More attractive to pay down a mortgage (interest not deductible).


 * Maryland No special tax issues.


 * New Jersey Prefer Roth to traditional accounts except for 401(k)'s (traditional IRA, 403(b), 457, Thrift Savings Plans are not deductible). Prefer Treasury bonds in a traditional IRA (not taxed; it is not clear from the instructions whether this applies to other traditional accounts).  More attractive to pay down a mortgage (interest not deductible).  Prefer Treasury bonds in a Health Savings Account (other investments are taxed).


 * Pennsylvania Minor preference for Roth over traditional accounts (neither is taxed in PA, but you may pay tax on traditional account withdrawals if you retire in another state). More attractive to pay down a mortgage (interest not deductible).

Tax details

 * Arizona Social Security is not taxed.  Income tax paid to other states is deductible.  Credit for taxes paid to a foreign country, computed as for credit to taxes paid to another state.  Part-year resident taxes are not prorated.


 * California Health Savings Accounts are not recognized: employer contributions are taxed as income and employee contributions are not deductible, but then distributions not used for qualified medical expenses, and included in federal income, are not taxed. All interest from tax-exempt mutual funds is taxed unless at least 50% of the assets are in bonds not taxed by CA.  Social Security is not taxed. Unemployment compensation is not taxed.  You cannot deduct Private Mortgage Insurance, estate tax paid on income in respect of a decedent, or tax paid on generation skipping transfers.  You cannot deduct losing CA lottery tickets as gambling losses.


 * Indiana All municipal Income exempt from Federal taxes is exempt from Indiana taxes no matter which state it comes from.  State income tax deducted from federal tax as a non-itemized deduction (on schedule C, C-EZ, E, or F) is taxable.  Unemployment compensation is taxed in full.  Social Security is not taxed.  No general standard or itemized deductions, but limited deductions for property taxes and renters.  9% of federal earned income credit allowed as state credit.  Counties can charge an income tax that is paid with the state tax; tax paid to another state can be takes as a credit against state tax, and tax paid to an out-of-state county or city can be taken as a credit against county tax.


 * Maryland Social Security is not taxed, and retirement income (up to a limit) is not taxed for taxpayers over 65. 50% of federal earned income credit, plus a county credit, allowed as state credit.  Itemized deductions allowed only if deductions were itemized on the federal return; standard deduction may be taken even if itemized deductions were taken on the federal return. Counties charge an income tax that is paid with the state tax; tax paid to another state can be taken as a credit against state tax, but neither tax paid to another state nor to an out-of-state county can be taken as a credit against county tax.  Part-year resident taxes are not prorated, but this has little effect because the tax rate is almost flat.


 * New Jersey No deduction for IRAs, nor any retirement plans other than 401(k) plans; non-deductible portion is not taxed on withdrawal. Health Savings Accounts are not recognized: contributions are not deductible and income earned is taxed.  Capital losses exceeding gains may not offset ordinary income nor be carried over to future years.  Medical insurance paid by payroll deduction (Section 125 or "cafeteria" plan) is taxed.  Income and capital gains on NJ and Treasury bonds (including the prorated portion of a fund with 80% of its assets tax-exempt) are not taxed, even in IRAs.  Retirement income (up to a limit) is not taxed for taxpayers over 62.  Deductions allowed only for medical expenses in excess of 2% of income, and property taxes (also 18% of rent paid by renters assumed to be property tax).  20% of federal earned income credit allowed as state credit.  Part-year resident taxes are not prorated.


 * Pennsylvania PA law allows deductions for medical and health savings account contributions, and IRC Section 529 tuition account program contributions (not IRA or 401(k) contributions). There is no standard deduction or personal exemption. There are 8 classes of income, taxed at different rates (PA Tax Compendium). Capital losses may not be deducted against capital gain distributions from mutual funds, only against actual capital gains, and may not be carried over from previous years. Social Security is excluded.  Retirement plans withdrawals, pensions, and IRAs are not taxed if withdrawn after meeting the age requirements; otherwise, any net gains (such as withdrawals from an IRA before 59-1/2) are taxed.  (PA PIT Guide - Chapter 7: Gross Compensation contains detailed tables of what's included, not included.)

Issues to check when adding a state to the list
Here are some of the more common issues which should be mentioned:
 * No income tax, or tax applied only to some types of income (investments but not salary).
 * Municipal bonds from other states not taxed.
 * State taxes some income excluded from Federal income on W-2 (e.g., 401(k) or 403(b) contributions).
 * Tax exemptions for Social Security or retirement income.
 * Taxation of Health Savings Accounts.
 * Minimum fraction of income or assets in tax-exempt assets for mutual funds to be exempt from state taxes.
 * No standard deduction.
 * Only specific items may be deducted, rather than most Federal itemized deductions.
 * Significant additional deductions such as Federal tax or tax paid to other states.
 * Taxpayers must itemize state deductions if they itemize Federal deductions, or must take state standard deduction if they take Federal standard deduction.
 * Different types of income taxed at different rates.
 * Earned income credit.
 * Part-year resident income is not prorated, in states with progressive tax rates. (If the tax rate is flat, proration is irrelevant, as the tax on $20,000 is 20% of the tax on $100,000.)

The Specific Issues for Investors section should be kept short; only those issues which are relevant to a large number of investors (such as non-deductibility of mortgage interest or taxability of different types of investment income) should be mentioned there.