The clock is ticking toward the end of tax season, and across the nation, taxpayers are scurrying to get their federal income tax returns done.
In many cases, the numbers that you’ll report on your state income tax return will be identical to what you put on the forms you’ll send to the IRS.
However, every state is different, and there are some exceptions that require you to come up with numbers for state income tax purposes that are different from what you’ve provided on your federal return.
Below are three of the most common examples.
1. What counts as income
Not every state taxes the same type of income as the federal government does. Many of the most common types of items — including wages and salaries, investment income, and profits from self-employment or a small unincorporated business — tend to be treated similarly by most states as they are federally. However, there are some big areas in which you’ll often see differences.
The most prevalent difference between federal and state income applies to older taxpayers with pensions or similar retirement-related income.
For instance, 37 states never tax Social Security income, even for those taxpayers who have to pay federal income tax on a portion of their benefits.
In addition, a handful of states choose not to tax pension income at all, while many others have partial exemptions that can either reduce or eliminate taxation of certain types of pensions.
2. What deductions are available
Where states really differ is in what deductions they acknowledge. On one hand, you can often find state deductions that aren’t available at the federal level.
A common example involves contributions to 529 college savings plans, with many states choosing to give an incentive for residents to put money into their own home-state 529 plans by letting them deduct up to a certain amount of 529 contributions each year.
You’ll also find different amounts for standard deductions, as well as different menus of choices for taking itemized deductions. Some states simply have taxpayers take these deduction amounts directly from the federal return, but you’ll also find instances in which you have to do your own calculation using a specific set of rules that can produce different deduction amounts.
In a few cases, state income tax laws refuse to acknowledge deductions that federal law recognizes. For instance, retirement contributions that are excluded from income for federal purposes can be required to be included at the state level. Overall, these situations are reasonably rare, but they come up often enough that it’s important to be prepared for them.
3. What tax rates apply
Finally, you’ll find a wide range of different ways that states like to set their income tax rates. Some closely resemble the same sort of strategy that the federal government uses, but others make things a lot simpler.
The majority of states that impose income taxes have multiple tax brackets with tax rates that rise as income goes up. For example, California has even more tax brackets than the IRS has, with the lowest imposing a 1% tax rate but the highest coming in at 12.3%.
The idea here is the same as it is for the federal government, advocating for a progressive system that collects more taxes from those in a financial position to pay them.
However, there are several states that have a flat income tax. For these states, it’s trivial to come up with how much tax you owe once you know your taxable income. Although some see flat taxes as being relatively regressive, you’ll find that states with flat income taxes sometimes have other ways of collecting revenue that take income and wealth levels into account.
Doing double duty
Having to file both federal and state income tax returns adds to the burden that most Americans face every April, but it doesn’t have to be unnecessarily complicated. By understanding how federal and state income tax rules can differ, you’ll be better prepared to handle preparing both of your returns correctly.
— Dan Caplinger
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Source: The Motley Fool