How State Income Taxes Work


For many states, the largest source of revenue is state income tax. See more tax pictures.
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Taxes -- they are those pesky percentages tacked on to every dollar you spend, every dollar you earn and everything you own. As Benjamin Franklin once famously said, "…in this world, nothing can be said to be certain, except death and taxes." And it certainly seems that way, sometimes. But taxes can serve a very useful purpose -- they help to run our government, and without them, many of the services we enjoy every day would not exist. The roads you drive on, the schools you attend and send your children to, the parks you have picnics in and even the hospitals you turn to when you're sick are all paid for, at least in part, by your tax dollars.

Most of the taxes you pay go to the federal government, but some go to the government of the state you live or work in. And depending on which state you call home, and how much money you make, the part of your income that belongs to the government can be really small or really big.

State governments get some of their operating money from the federal government, but most of the rest of the money they need to operate comes from taxes. State governments collect all kinds of taxes, many of which you probably know about (like sales tax) and some that you may never have heard of (like severance tax). But for many states, the largest source of revenue is income tax -- a tax on any money that people or businesses in the state earn. Even though in this article we'll focus on the individual income tax -- the tax on the earnings of individual people, keep in mind that businesses have to pay tax on the money they earn as well.

Income taxes can be pretty complicated, especially if you consider that many of the fifty states collect different types of income taxes, different rates of income taxes and some states collect no income tax at all. Each state even has its own rules about who is taxed and how they're taxed. So how can you make sense of it all? And what happens if you live in more than one state? Or join the military? Or have a really low income? Well, to answer these questions, we need to start at the beginning and understand what exactly the income tax is, well, taxing.

 

What, exactly, is being taxed?

Income taxes are based on the amount of money you earn, or your income. Income includes the money you make at your job, interest you earn on things such as savings accounts and investments, money you earn from rental properties, money you win gambling and pretty much anything that adds to your financial worth over the course of the year.

The tax on this income is the percentage of your income the government takes. Depending on the state you live in, this income tax can be anywhere from nothing to almost 11 percent of your income. Add this to the up to 35 percent that the federal government can take, and that's a big chunk of your income that goes right to the government. But don't worry, that money is used for many things that benefit you. Plus, the U.S. income tax rates are about average compared to other countries. As a citizen of Denmark, for example, you could pay up to 59 percent of your income in taxes [source: Worldwide Tax]!

When calculating your taxes, you usually figure out how much money you owe to the federal government before you figure out your state taxes. That's because some of the calculations you do for your federal taxes are used to help calculate your state taxes.

The most important calculation is your adjusted gross income. This is the amount of your income that can be taxed after you have taken any deductions and exemptions that are applicable to you. Deductions reduce the amount of tax that you owe. There are all kinds of deductions out there, many of which the government uses to encourage spending in certain areas. For example, the government offers tax credits for going to college, donating to charity or buying your first home.

Most states base their taxes on the adjusted gross income you calculated for your federal taxes. They might modify the amount after that, but usually it's helpful to know your federal adjusted gross income before starting in on your state taxes.

Even though most states use your adjusted gross income as the basis for taxation, different states choose to tax that income differently. In the next section, we'll look at the two main types of income taxes and figure out which states use each type.

Types of State Income Taxes

There are two different types of state income taxes -- flat taxes and progressive taxes.

A flat tax is just what it sounds like: a flat rate, or a fixed percentage of your income. So, for example, people who live in Utah pay 5 percent of their income in state income taxes, no matter how much money they make. This type of tax is also known as a proportional tax, because the amount you pay is proportional to your income. Seven states have flat income tax rates: Colorado, Illinois, Indiana, Massachusetts, Michigan, Pennsylvania and Utah.

A progressive tax (or graduated tax), on the other hand, varies depending on how much money you make. The more you earn, the larger the percentage of your income goes to the government in the form of taxes. Thirty-six states have a progressive tax. Your federal taxes are also progressive.

The main advantage to a progressive tax is that those who have the least ability to pay (have the lowest incomes) pay the smallest percentage of their income in taxes. The progressive tax system is often defended by the ability-to-pay principle, or the idea that those with the greatest ability to pay will least mind paying a higher tax rate.

Some people think that a progressive tax is unfair because it charges different people different percentages of their income. They see a flat tax as a fairer way to tax, since everyone is taxed at the same rate.

While living in a state with a progressive tax system benefits those who earn the least, the most beneficial to everyone -- whether they earn a lot or a little -- is living in a state with no income tax at all. In the next section, we'll examine the seven states that do not charge their residents income tax, and figure out how they manage to survive without it.

Tax-free States

Currently, there are seven states that do not have an individual income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. Two additional states -- New Hampshire and Tennessee -- only charge tax on interest earnings and dividends from owning stock, so essentially, they have no income tax.

How do these states get enough money to operate their governments without an individual income tax? When it comes to taxes, each state has to look at its assets and consider what taxes would bring in the revenue it needs. In some cases, charging an income tax is not as useful as charging other types of taxes.

Take Wyoming as an example. Wyoming has a population of only slightly more than half a million people. With a population that small, relying on a personal income tax just wouldn't bring in enough money for the state government to run itself. But what Wyoming does have is natural resources, so it's not surprising that two of the state's largest revenue sources are severance taxes (taxes on the removal of natural resources) and mineral royalty taxes (a tax on revenue earned from selling minerals from the state). Plus, with a small population and a lot of open land, Wyoming doesn't need as many government services, like highways and hospitals, so the state can easily survive without charging an income tax.

Another good example is the state of Nevada. Like Wyoming, Nevada does not have a personal income tax. Instead, the two largest sources of revenue for the state are sales taxes and gaming (gambling) taxes. This is not surprising since Nevada casinos are a popular tourist destination.

Because each state is different -- each has a different population, different resources, different potential sources of income and different needs -- it's left up to each state to decide how best to generate its own revenue. If each state was limited to bringing in, say, a 5 percent flat tax on income, states like Wyoming and Alaska (which have small populations) would probably not bring in enough money to function properly.

So, how and when are you expected to pay state income taxes? Keep reading to find out how the money gets from your bank account to the government's hands.

When and how do you pay?

Most of the taxes you owe are paid throughout the year. Sales taxes are paid at the time of purchase. Property taxes are usually rolled into your monthly mortgage payments. Income taxes, however, can vary.

For most people, individual income taxes are automatically taken out of their paychecks. This is called payroll withholding. If you look at your pay stub, it usually tells you exactly how much money has been deducted in taxes.

But some people's taxes aren't deducted from their paychecks at all. This might be the case if you own your own business or work as a freelancer. In that case, it's up to you to pay the right amount of taxes you owe. The deadline for paying your taxes for the calendar year is April 15 of the following year. So, for example, you must file your 2009 taxes by April 15 of 2010.

One thing to keep in mind is that even if your taxes are automatically taken out of your paycheck, that doesn't mean you can ignore the April 15 deadline. Your payroll withholding is only an estimate of how much you owe in taxes. At the end of the year, you're still expected to calculate the actual amount you owe. You'll figure out how much you actually owe by following the instructions that come with your state's tax forms. Each state is different, so it has different forms and different instructions to follow. A good place to find more information about your state's tax forms and tax rules is your state government's Web site.

When you calculate your taxes, sometimes you'll find that not enough money was taken out of your paycheck and you'll owe more money to the government. However, you might find that you paid too much and the government owes you money instead. That's why some people love tax season (because they get money back) and others despise it (because they owe money to the government).

Whether you love it or hate it, you have to admit that the U.S. tax system can be pretty complicated. We've talked about the different types of state income taxes and the different rates of these taxes, but the complications don't end there. Believe it or not, there are still more exceptions to the rules. Read on to find out what happens when you live in more than one state or if you join the military.

Exceptions to the Rules

Because military personnel spend time living and working in many different states or countries, they are expected to pay taxes to the state they lived in when they first enlisted.
Because military personnel spend time living and working in many different states or countries, they are expected to pay taxes to the state they lived in when they first enlisted.
Comstock/Getty/Thinkstock

For many people, filing state income taxes is a simple process. However, for some, it can be much more complicated. The state income tax system has some unusual exceptions. For instance, what happens if you live in one state and work in another? Does your income tax go to the state you live in, or the state where you earned the money? Well, that depends on which states you live and work in.

Most states require you to pay income tax in the state where it's earned. But some other states use residency as their basis for taxation. So in some situations, you could actually end up being taxed twice on the same income, unless the states have agreements with one another to prevent taxing your income twice. That's definitely something to consider if you're thinking about commuting across state lines.

A similar situation happens when you own homes in more than one state. Different states have different rules about residency, so the worst-case scenario is that you could be paying income taxes to multiple states. Usually, though, you pay taxes to the state that you list as your primary residence. That's why many people who own two homes will list their primary residence as the home located in the state with the lowest income tax rate.

Another exception in the state tax system exists for members of the military. As a member of the military you may spend time living and working in many different states or countries. You may even live on land owned by the federal government (military bases). To help alleviate any confusion, military personnel are expected to pay taxes to the state they lived in when they first enlisted. This could be beneficial for some, since a few states do not tax military pay, active duty pay or combat pay at all. Some other types of income that most states do not tax include unemployment income, Social Security benefits, military pensions and workers' compensation.

So now that you understand state income taxes, what you really want to know is which state is the cheapest to live in. Read on to find out which states allow you to keep the highest percentage of your income, and which states have their hands deep inside your piggy bank.

The Income Tax Burden

Before moving, retirees should take time to consider the tax burden of living in a particular state.
Before moving, retirees should take time to consider the tax burden of living in a particular state.
Digital Vision/Thinkstock

One thing people look at when comparing state taxes is the tax burden of living in each state. The tax burden is the total amount you would pay in taxes. Because each state has a different rate of income tax (and different rates of sales and other taxes), the tax burden can vary greatly from state to state. If you're nearing retirement and want to know which state you'll pay the highest income taxes in, comparing tax burdens is a good way to find out.

There are several ways to look at the state tax burden. One way is to look at the tax burden just for personal income taxes. That means comparing states based on how much the average person in each state pays in income taxes as a percentage of his or her income. In 2008, the state with the highest individual income tax burden was New York. In New York, you'll pay an average of $40.59 in individual income taxes for every $1,000 you make [source: Colorado Legislative Council]. That might not seem like very much, but remember that this amount is just for your state income taxes -- your federal income taxes are much higher, and there are still many other types of taxes you have to pay in addition to this.

The next four most expensive states are Massachusetts, Oregon, California and Minnesota [source: Colorado Legislative Council]. The states with the lowest individual income tax burdens are of course the seven states that do not charge an income tax at all.

Another way to look at the tax burden, and the most useful if you're using it as a basis for deciding where to live, is to include all of the taxes that are paid to the state -- including sales tax, property tax, and even corporate income taxes. In that case, Alaska has the highest tax burden, with an average of $309 paid in taxes for every $1,000 of income. The next four most expensive states in total taxes are Vermont, Hawaii and North Dakota. The least expensive states are New Hampshire, South Dakota, Colorado and Texas [source: Colorado Legislative Council].

For more information about income taxes, tax deductions, and taxes in general, take a look at the links on the next page.

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More Great Links

Sources

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