How State Income Taxes Work

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.

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