States are all over the board in their taxation of income. Some tax at a low rate, some tax at a high rate, and some don’t tax at all. Read on to learn more about state income taxation and how you could avoid it.
Everyone knows (or should know) that the federal government taxes the income you earn. But, depending where you live and how you earn money, states may tax your income, too.
States run the gamut in the income taxation of individuals. Seven states don’t tax you at all: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. A couple states, New Hampshire and Tennessee, only tax dividend and interest income. The other 41 states and the District of Columbia all tax individual income at various different rates. Eight states tax income at a flat rate, though they vary regarding personal exemptions for the taxpayer and their dependents. Those states are Colorado, Illinois, Indiana, Massachusetts, Michigan, North Carolina, Pennsylvania, and Utah. The other states have rates varying based on the income of the taxpayer. California wins the dubious distinction of having the highest marginal rate for top income earners at 12.3%, though other states aren’t far behind, especially since they may have local income taxes in addition to the state income tax.
If you’re a citizen of the United States, the federal government taxes you on your worldwide income. Only one other country in the world, Eritrea, taxes income based on citizenship. The United States also taxes residents of the United States on worldwide income. States tax similarly. If you’re a resident of the state, the state will tax you (if it has an income tax) on all your income, whether or not it is generated from sources within the state. Conversely, states typically tax non-residents only on the income derived from sources within the state. An example of a source within the state would be profits from operating a farm or renting real estate located in the state.
Those wishing to lower their income tax burden might seek to move their residence to a state that does not have a state income tax. Doing so would remove state income taxation. (Of course, if the income is sourced in a state that has an income tax, there might still be a non-resident income tax in the source state.) As prior articles have explained, a trust which is a grantor trust, such as a revocable trust, is taxed to the grantor of the trust. In other words, the income of the grantor trust is taxed on that individual’s tax return just like if they had earned the money themselves. As a result, if they are a resident of a state with an income tax, the worldwide income of a grantor trust is taxed to the grantor without regard to where the income is generated.
However, a nongrantor trust is taxed differently and may present an opportunity to avoid state income taxation, without having to move your personal residence. Next week’s article will explain how states vary in their income taxation of nongrantor trusts.