As most tax filers know, the annual tax season is a time of surprises. On rare occasions, the surprises are pleasant, and we owe less than we thought or will be getting a larger refund than we expected. However, most of the surprises we get during tax season are of the bad variety, and this is especially true if we are unprepared. A common surprise is finding out that we owe money to the state we live in but not the federal government. However, why does this happen? This article will cover this question, and it could also help you to get ready for the upcoming tax season and avoid unpleasant surprises.
So…Why Do I Owe State Taxes but Not Federal?
You may find yourself scratching your head if you file your incoming taxes and find out you owe state taxes but not federal. It happens sometimes, and here’s why: if the state you live in collects income tax, you will have to file a state as well as federal tax return.
The tax brackets and deductions are different at the state level, so the amount you owe the state will not match your federal income tax obligation. That’s why taxpayers sometimes owe money to their state governments even when they receive a federal tax refund.
Why Do I Owe State Taxes?
In most countries, people pay income tax to the central government and some sort of tax based on property values to their local authorities to cover services like garbage collection. In the United States, most people pay both federal and state income taxes as well as property taxes.
If you find yourself in a position where you have no federal tax obligation but owe state taxes, it is probably because your state’s deductions and tax rates are not as advantageous for you as the federal rules. State income taxes are a fact of life for the vast majority of Americans because most states collect them. The eight states that do not require their residents to pay income tax are:
- South Dakota
Why We Have Pay State Income Tax
State governments use the income taxes they collect to fund law enforcement agencies, build and repair roads and pay for important public services. This money is also used to cover the costs of health and pension benefits for state employees and state Medicaid programs. In seventeen states and the District of Columbia, counties cities and municipalities are also permitted to collect income taxes to meet their financial obligations.
This means many Americans pay federal, state and local income taxes, and the rates vary a great deal. For example, the city income tax in San Francisco is only 0.38%, but that figure rises to as much as 8.5% in the District of Columbia. Meanwhile, state taxes run from just 2.9% in North Dakota to up to 12.3% in California.
State vs. Federal Taxes
Both state and federal income taxes are collected to pay the costs of providing government and public services, but they are both calculated differently. Federal taxes are paid by almost every American adult that earns more than the standard deduction, but state income taxes are often only paid by individuals with higher incomes. The allowances and deductions that can be used to calculate the amount of tax owed also vary from state to state.
The federal government has a fairly generous standard deduction. It also allows taxpayers to itemize their returns instead and subtract expenses like mortgage and student loan interest, childcare expenses and even gambling losses.
State authorities also have tax brackets, credits and deductions, which are often quite different from the federal rules. When people owe income tax to the state they live in, but not the federal government, it is usually because the rules in their state do not work as well for them as the federal tax brackets and deductions.
The Main Differences Between State and Federal Taxes
There are several key differences between state and federal income taxes. These differences include:
- Tax returns: You will need to complete and submit a separate tax return if the state you live in collects income taxes. In some cities, you will also have to complete a local return and attach it to your state tax paperwork.
- The amount collected: State income taxes are far lower than federal income taxes. California’s top income tax rate is the highest in the country, but it is still only about a third of the federal government’s top tax bracket.
- Refunds: If you are due a refund on your state taxes, it will be paid by your state and not the federal government.
- Tax collection: State authorities pursue unpaid taxes vigorously, but they do not approach their duties with the same zeal as the IRS.
- Tax spending: Much of the income tax money collected by the federal government is used to pay for the military and provide aid to foreign countries. But state taxes cover the costs of providing local public services.
Every State Has a Different Method of Calculating its Taxes
While the federal tax rules are the same all over the country, states all have their own way of determining how much their residents should pay. That is why it is a good idea to look at the deductions available as well as tax rates when choosing where to live.
States with a high basic income tax rate may not be as expensive as they look if their deductions are generous, which means living in states that seem more tax-friendly could actually be just as costly. Oregon’s income tax rate is a relatively modest 4.75%, but its standard deduction for single taxpayers is $2,080, which is not too shabby. The earned income tax credit is also far lower, and some popular federal income tax deductions are not available.
Is it Possible to Owe Taxes in More Than One State?
Yes, there are a few situations where individual taxpayers are required to pay income taxes to more than one state. This is usually because a taxpayer moved between states during the tax year, but it can also happen when they live in one state and work in another.
Individuals rarely have to pay the full tax rate because states that border one another usually have reciprocity agreements. The lower amount they have to pay under these agreements is often called a commuter tax. If you moved during the last year or travel between states to commute to and from work, you may have to file tax returns and pay income taxes in more than one state.
Also, eCommerce business owners that conduct business out of state can wind up paying taxes in one or more states. That’s because of new economic nexus laws that require them to collect & remit sales tax once they meet sales and transactional thresholds. These thresholds and guidelines can differ by state, and no physical presence is needed to be eligible for nexus taxes.
The Various Types of Taxes You Could Wind Up Paying
State governments raise taxes to collect the money they need to pay their bills, and income taxes are only a small part of the picture. People who live in one of the states that do not have an income tax usually pay higher property and sales taxes to make up for the lost revenue. Therefore, the amount these residents pay is more or less the same. However, some states are more tax-friendly than others.
When states do collect income taxes, they either apply a flat rate or use tax brackets like the federal government. When a flat tax rate is in place, state residents pay the same tax percentage regardless of how much they earn. The nine states that have a flat income tax are:
- North Carolina
Every other state that collects income taxes has tax brackets based on income similar to the federal government. However, calculating state taxes is not as challenging or expensive as there are usually far fewer brackets to work with and the rates are a lot lower.
How State and Federal Withholding Tax Works
The taxes deducted from your paycheck are based on federal, state, and local tax rates and the paperwork you completed during the hiring process. The money deducted by your employer is submitted on a regular basis to state or federal tax authorities, and it is used to determine whether you get a refund when you submit your tax returns.
Preparing your taxes is a bit like doing an audit to find out if you paid the right amount (vs. not enough or too much). You can put more in your pocket each week by claiming that you have a lot of dependents, but you will have to pay all that money back when you file your taxes. Putting false information on official paperwork can also lead to fines and other penalties, so it’s best to be as honest as possible.
State Income Tax vs. Federal Income: California Example
Let’s take California as an example to show the difference between state and federal income taxes. Here are some of the key differences:
- Standard deduction: The standard deduction for a single taxpayer is currently $12,550. In California, single taxpayers can deduct $4,803.
- Tax rates: Federal tax brackets go from 10% for incomes between $10,000 and $19,999 to 37% for those earning more than $523,600. In California, the lowest tax bracket is 1% and the highest is 12.3%. However, state lawmakers are considering raising the top income tax rate to over 16% to cover growing budget deficits.
- Deductions: The deductions in California are sometimes higher than the amounts allowed by the federal government. For example, mortgage interest in California is deductible on loans of up to $1 million because the price of real estate is high. The federal government draws the line at $750,000.
Questions About State Income Taxes
I keep owing taxes to the state. What should I do?
If you find yourself having to write a check to your state tax officials each year, it is probably because the amount being deducted from your paychecks by your employer is not enough to cover your obligations. To prevent this from happening, you can talk to your human resources department or tax preparer to find out how to adjust your withholdings. Your paycheck will be a little lower, but you won’t have any nasty surprises when tax season rolls around.
Can owing state taxes impact my federal taxes?
State and federal taxes are completely separate. They are collected by different agencies and spent on different things. However, they can affect each other. The amount you pay in state and local taxes can be deducted on your federal return, which can be a boon in states like California. What is known as the SALT deduction has become a hot-button political issue, so you can expect it to go up and down in the years ahead.
Will the IRS hold back my federal refund if I owe money to the state?
Most people who owe state taxes receive their federal tax refunds without issue, but state authorities can contact the IRS to garnish these funds. This involves spending both time and money, so it is usually only done when the sums involved are high. If your refund does not amount to tens of thousands of dollars, you will almost certainly have no problems.
I owe state taxes but I’m getting a federal refund. Why?
A lot more people asked this question after the Tax Cuts and Jobs Act was passed in 2017. This usually happens when federal tax rates are lowered, or deductions are changed while state rules remain in place.
How do I find out if I owe state taxes?
Completing a state tax return is the only surefire way to find out for sure what you owe or how big your refund will be. This can be difficult in states with myriad tax brackets and deductions and mistakes can be expensive, so you should consult a qualified tax expert to help you.
Expert Help When You Need It
If you live in a state that collects income tax and you are worried about how much you might have to pay, the experts at the Tax Crisis Institute can help you. We have been assisting people with tax issues for almost 40 years, and we always work hard to make sure that our clients don’t have to pay a penny more in tax than is necessary. To learn more about our services and the ways we can lower your tax bill, you can call one of our offices or use our online form.