Dealing with the Tax Man: Filing State Taxes

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Most states rely on some form of income tax to fund their expenditures. And, in most cases, those tax returns are reasonably easy to prepare because they piggyback on your federal return, using either the adjusted gross income you've calculated on your Form 1040, 1040A, or 1040EZ as a jumping-off point, or the federal taxable income. From either of those points, you may add some items of income not taxable for federal purposes, subtract others, and do some other math calculations to arrive at your state's taxable income.

Some states (Colorado, Illinois, Indiana, Massachusetts, Michigan, Pennsylvania, and Utah) apply a flat income tax rate; others use a graduated scale. State income tax rates are almost always lower than the corresponding federal taxes, but many states begin taxing amounts that are lower than the federal thresholds, or don't allow as much for deductions or exemptions. You may find that you owe state income taxes even though you don't owe anything to the IRS.

Of course, not every state follows the so-called piggyback model in income taxation. Massachusetts, for example, requires that you start at square one on Form 1. And New Hampshire and Tennessee tax only dividends and interest, not wages, rents, or capital gains. Still other states have no personal income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.

What may make preparing your state income tax returns a bit tricky is that certain items of income that are taxable on your federal return aren't taxable on your state return. These items primarily include interest earned from U.S. Treasury obligations (U.S. Treasury bonds, notes, and bills, as well as some Federal Home Loan Bank and Federal Farm Loan Bank obligations [which are bought and sold just like other government bonds], but not any federally backed mortgage obligations, such as GNMA or FNMA).

Other items that aren't taxable on your federal return are taxable on your state return, such as tax-exempt interest earned on municipal bonds from other states. So, if you live in Vermont and own a New York municipal bond, you won't pay income tax to the IRS on the interest, but you will pay tax to Vermont. Remember, though, municipal bonds from Puerto Rico, the U.S. Virgin Islands, American Samoa, and any other U.S. possession or territory are tax-exempt not only federally, but also in every state.

If you live in one state for the entire year and you only own real estate or business interests (including pieces of real estate or closely held businesses that may be owned by a partnership, tenancy-in-common, or even a Subchapter "S" Corporation) located in that state, you have to file an income tax return in only one state. But if you own a rental property in another state, participate in a business that operates across state lines, or live in one state and work in another, you have nonresident source income and must file a tax return in (and pay tax to, if you have enough income) a second state. Likewise, if you moved partway through the year from one state to another, you need to file state returns in each state where you lived and earned money. Don't worry that you'll end up overpaying your taxes. Every state gives credit for taxes paid to other states, so you end up paying tax in each state only on either your income while you were living there or the income derived from sources inside that state. If you're required to file multiple state returns, you may want to consult a qualified tax advisor; calculating which state is owed what tax can sometimes get pretty confusing.

This article was authored by Ted Benna, Stephen R. Bucci, James P. Caher, John M. Caher, N. Brian Caverly, Peter Economy, Jack Hungelmann, John E. Lucas, Sarah Glendon Lyons, Margaret A. Munro, Brenda Watson Newmann, Mary Reed, Jordan S. Simon, Kathleen Sindell, Deborah Taylor-Hough, John Ventura.