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.

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 and earn $100,000, of which $20,000 was earned 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.

Reciprocity with neighboring states
States that impose a personal income tax generally require that tax be paid on all income earned in that state. 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.

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 New Jersey and 4 other states) could have taxes withheld at the PA rate. Only a PA state tax form is needed; no additional forms are to be filed for New Jersey.

As an additional example, Virginia residents who work in Maryland pay only Virginia tax on the income and do not normally need to file Maryland tax forms.

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.

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.


 * 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 because Indiana taxes are based upon Federal Adjusted Gross Income (AGI).  However, on the negative side Indiana does add back certain taxes deducted from federal Schedules C, C-EZ, E, and F.  It also adds back other federal special cases such as special disaster assistance and unemployment compensation when it is exempted from federal taxes.  On the positive side it lets you take off the Social Security and Railroad Retirement income in the Federal AGI, along with interest on direct U.S. government obligations even if it only represents part of the income from an asset.  Indiana has partial deductions for property taxes and renters.  Indiana earned income credit is based upon the federal earned income credit.  Indiana charges a Use tax on out-of-state purchases - the sales tax you save at time of purchase, has to be added into your income taxes. In addition to the base state income tax, Indiana allows counties to charge an income tax that is paid with the state tax.  Health Savings Account along with several other items exempt from federal taxes can be exempted from the county income taxes.


 * 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 allowed as state credit.


 * 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 from previous years may not be carried over.   Medical insurance paid by payroll deduction (Section 125 or "cafeteria" plan) is taxed.  Mutual funds may only exclude tax if 80% of the fund is invested in tax-exempt assets.  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.


 * 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). Social Security is excluded. A premature withdrawal from a regular IRA or Roth IRA is taxable as compensation to the extent that the taxpayer receives an amount that exceeds his or her previously taxed contributions. (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).
 * 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, and only specific items may be deducted.
 * Significant additional deductions such as Federal tax.
 * Taxpayers must itemize state deductions if they itemize Federal deductions.
 * Different types of income taxed at different rates.
 * Earned income credit.