Beware of Differences between Federal and State Income Taxes

Much attention is focused on federal income taxes. For many individuals, state income taxes also represent a substantial expenditure. For example, Hawaii has the highest state income tax rate of 11% on taxable income over $200,000 (Oregon has the same rate for taxable income over $250,000).

States, however, often adopt rules that can differ from federal income tax rules, providing its citizens with additional tax incentives or breaks. There is no state income tax in Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming; New Hampshire and Tennessee tax only interest and dividends.

Here are some areas to look out for in states with income taxes. These lists are not intended to be complete discussions of state income taxes but merely to show how different they can be from federal income taxes.

Filing Status

Federal law lets couples who are married on the last day of the year file joint returns. If they choose, they can use a filing status called married filing separately. This status, however, often prevents one or both spouses from claiming certain deductions or other tax breaks. For example, if one spouse filing separately itemizes, the other must do so, too, and cannot use the standard deduction.

Some states may permit alternative filing for married couples. In Arkansas, Delaware, and Georgia, for example, married couples can file joint returns or combined returns. Under the alternative of combined returns, each spouse is taxed separately. If both spouses have income, the alternative filing status allows each spouse to benefit from the low tax rates at the beginning of the tax rate schedule.

Retirement Income

Under federal law, distributions from retirement accounts, such as 401(k) plans and IRAs, are fully taxable. States, however, have a wide range of tax breaks for this income. These breaks differ from state to state, but include:

• Alabama exempts civil service and government pensions; Arizona exempts only $2,500 per year of such pensions.
• Connecticut exempts 50% of military retirement pay.
• Georgia exempts 50% of retirement benefits, including payments from pensions and annuities.
• Illinois, Georgia, Mississippi, and Pennsylvania exempt all distributions from IRAs, 401(k) plans and other retirement benefits for those meeting age requirements; only a dollar amount is exempt in Iowa, Louisiana, Maine, New York, and North Carolina.

Under federal law, Social Security benefits may be includible in gross income at 50% or 85% of benefits or may be fully tax free, depending on the recipient’s other income as well as tax-exempt interest. States may be more or less generous in their tax treatment:

• Arkansas, Arizona, California, Delaware, Georgia, Hawaii, Illinois, Indiana, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Michigan, Mississippi, Missouri, Montana, Nebraska, New Jersey, New Mexico, New York, North Carolina, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, South Carolina, Utah, and Virginia exempt all Social Security benefits.
• Colorado exempts benefits up to $24,000 per recipient age 65 or older.
• Connecticut exempts benefits only if income is below set levels.
• Iowa and Wisconsin tax 50% of benefits.
• Utah allows a deduction for the federal portion that is taxable, but the deduction phases out for high-income taxpayers.
• Kansas, Minnesota, New Mexico, Rhode Island, Vermont, and West Virginia follow the federal rule.

Bond Interest

Interest on U.S. savings bonds is usually taxable for federal income tax purposes. It can be partially or fully tax free if the bond proceeds are used to pay for higher education and the bondholder’s income is below threshold amounts. States do not tax any interest on U.S. savings bonds.

Interest on municipal bonds (other than certain Build America bonds) is tax free for federal income tax purposes. States have their own regime when it comes to taxing interest on municipal bonds.

• Some taxes exempt the interest on their own bonds but tax the interest on bonds of other states. These states include Arkansas, Arizona, California, Colorado, Connecticut, Delaware, Georgia, Hawaii, Idaho (for some bonds), Kentucky, Louisiana, Maine, Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Missouri, Montana, Nebraska, New Jersey, New Mexico, New York, North Carolina, North Dakota, Ohio, Oregon, Pennsylvania, Rhode Island, South Carolina, Vermont, Virginia, West Virginia, and Wisconsin.
• Some exempt interest on all state bonds. These states include Indiana as well as the District of Columbia.
• Some tax interest on all state bonds. These include Illinois, Iowa, Kansas, and Oklahoma (although some bonds in these states are exempt).
• Utah exempts interest on Utah bonds as well as bonds of states in which interest on Utah bonds is exempt.

Other Income

Some income that may be taxable under federal law is exempt for state income tax purposes. For example, New Jersey, Oregon, and Virginia exempt a portion of state lottery winnings. Pennsylvania exempts all unemployment benefits.

South Carolina offers a 44% exclusion for long-term capital gains; Vermont has a 40% exclusion; and Wisconsin has a 60% exclusion.

Deductions

Some states offer additional deductions to federal law; others may not include all federal deductions. For example, Alabama, Maine, New Jersey, and Wisconsin do not provide deductions for contributions to health savings accounts.

Iowa, Louisiana, Michigan, Mississippi, Nebraska, New Mexico, New York, Ohio, Oregon, Pennsylvania, Utah, and Wisconsin give residents a limited deduction for contributions to their states’ 529 plans (some states restrict the deduction for contributions to prepaid tuition plans); no federal deduction for contributions is allowed.

Hawaii gives residents a deduction for contributions to individual housing accounts and interest on such accounts, to enable savings for a down payment on a personal residence; there is no similar federal savings program.

Indiana gives residents a deduction for rent on their principal residence; no such federal deduction is allowed.

Missouri gives residents a deduction of up to $5,000 ($10,000 on a joint return) for federal income taxes paid.

Massachusetts, on the other hand, bars deductions for one-half of self-employment tax and contributions to self-employed retirement plans; these deductions are allowed under federal law.

North Dakota and Rhode Island offer a deduction for certain venture capital investments.

Tax Credits

Some tax credits on the federal level are transformed into deductions at the state level. For example, North Carolina gives deductions for the Hope and Lifetime Learning Credits. Oklahoma and Rhode Island allow a deduction for adoption expenses. West Virginia offers a deduction for the elderly and permanently disabled.

Some states give credits that are not available on the federal level. For example, New York allows a 20% for premiums paid for long-term care insurance.