As the end of the year approaches, taxes begin to weigh more on people's minds. Many taxpayers make the majority of their gifts to charity at the end of the year, partially to take advantage of their last chance to get charitable tax deductions for 2006. In general, it's a good time to take stock of what you can expect to pay the IRS next April and what you can do to reduce your taxes in 2007.
Unfortunately, for the vast majority of Americans, worrying about income taxes doesn't end when you've completed your 1040. Taxpayers in 43 states also have to worry about paying income taxes to the state in which they live. In addition, residents of some cities, including New York, Philadelphia, and Washington, D.C., must pay additional taxes based on income (of course, residents of the District don't have a state to pay taxes to, so they just pay their federal and city taxes). In considering the appropriate strategies to manage your taxes, you have to take these taxes into account.
States and their income taxes
Unlike federal tax rates, which apply uniformly across the country, state income tax rates differ markedly from state to state. However, the structure of tax rates in most states mirrors the federal system's use of multiple, progressive tax brackets based on income levels. In the states with the highest tax rates, including California, Oregon, and Vermont, marginal tax rates on income can reach 9% or more for those taxpayers in their highest brackets. On the other hand, a number of states, including Illinois, Michigan, and Pennsylvania, impose flat taxes with just a single bracket for all taxpayers. In two states -- New Hampshire and Tennessee -- the state income tax applies only to interest and dividend income, rather than wages and other earned income.
For most taxpayers, state income tax liability is relatively small compared to the amount of federal income tax they owe. Just as most people have money withheld from their paychecks throughout the year to cover their federal tax liability, employees in states with an income tax generally also have additional withholding that corresponds to what they'll owe in state income tax. In the same way that taxpayers must pay attention to their federal withholding to avoid incurring penalties, those who don't have enough state tax withheld may find themselves owing some extra money when April comes.
If it's a tax, it can't be simple
It will probably come as no surprise that the rules most states use to calculate their income taxes work differently from those used by the federal government. Of all the states with an income tax, only Rhode Island calculates its income tax as a percentage of federal income tax liability, and even it uses out-of-date federal tax brackets in determining taxpayer liability. Everywhere else, while you may be able to draw some of the figures from your federal tax return, there are substantial adjustments that you must make before arriving at a final result.
For instance, states are not allowed to tax income that derives from federal government obligations, such as interest from U.S. savings bonds or Treasury securities. Therefore, when you calculate your taxable interest for state tax purposes, you generally have to subtract any government interest from your federal taxable interest to come up with the right number. Conversely, although interest from state and local obligations, such as municipal bonds, are exempt from federal taxation, states usually recognize only bonds issued within their own boundaries as tax-exempt. As a consequence, you usually have to add back in such interest to come up with the correct figure.
For those taxpayers who own mutual funds, the calculations involved can require great attention to detail. Many mutual fund companies produce large packets of tax-related materials at the end of each year to guide their investors through the many different rules imposed by state tax departments. In many cases, a portion of your mutual fund income may be subject to different tax treatment at the state level than on your federal tax return.
There are a huge number of other potential differences between federal and state tax rules. For instance, if you get substantial income from dividends on stocks like ExxonMobil (NYSE:XOM) or General Electric (NYSE:GE), don't expect to see the same preferential tax rates that federal tax law gives to stock dividends. Some states tax items like unemployment and Social Security benefits differently from the IRS. Allowable deductions may vary greatly from state to state; whether or not taxpayers are allowed to deduct the amount they pay for federal taxes is perhaps the most significant difference among states. Many states offer tax credits for items that have no federal counterpart. Often, certain states will adopt the same changes made to federal tax laws, but only on a delayed basis, meaning that relatively new federal tax provisions may not apply on your state tax return until several years later.
Even extremely basic things like whether or not you have to file or what filing status you should choose don't necessary carry over from the federal rules to your state's requirements. In some situations, taxpayers whose income levels are so low that they don't have to file a federal return at all may nevertheless have to submit a return and even potentially pay tax to their state department of revenue. In addition, married couples who file jointly for federal purposes may find it advantageous to file separate returns on the state level, requiring the spouses to separate out their respective items of income and expense to calculate the appropriate tax. On the other hand, because the IRS has thus far refused to acknowledge same-sex marriages as a basis for filing a joint return, same-sex couples in some states may end up filing jointly on their state returns, while having to file as single individuals for federal purposes.
When it comes to taxes, few things are ever simple. As if the Internal Revenue Code governing federal taxation weren't complicated enough, the various rules that apply in calculating state income tax adds an entirely new layer of difficulty to an already arduous process. Unless you're in a position where you can move to Alaska, Florida, Nevada, South Dakota, Texas, Washington, or Wyoming, there's little you can do to avoid the extra work that your state income tax will force you to do.
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Whenever you have questions about your taxes, take a look at The Motley Fool's Tax Center. Foolish tax expert Roy Lewis and many other contributing writers provide you with helpful insight on common issues facing taxpayers, as well as in-depth commentary of new tax law changes as they take effect.
If you're considering making end-of-year, tax-wise charitable donations, check out www.foolanthropy.com for ideas on five very Foolish charities and to read up on our latest articles related to charity, including wise-giving tax strategies.
Fool contributor Dan Caplinger will get to file two state income tax returns this year, but he's not too disappointed. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy can be found here.
