While all taxes are mandatory payments that fund various government services, the taxes you pay at the federal and state levels vary in several ways, and the processes for preparing and filing them also differ. In this guide, we’ll detail all these distinctions and provide valuable tips for reducing your federal and state tax liabilities.
The primary difference between federal tax vs. state tax is who collects the money. While U.S. taxpayers send federal income tax returns to the Internal Revenue Service, each state also has a separate taxing authority. For example, in Colorado, the Taxation Division of the Department of Revenue administers and enforces the state’s income, sales and property taxes.
Ultimately, federal and state taxes have the same purpose, but on different levels. For example, your federal taxes fund things like the military, the president and Congress. On the other hand, your state taxes pay for local roads and the governor’s salary.
If you live in a state that collects state income tax, you’ve probably noticed state taxes withheld from your paychecks alongside federal income taxes. Though the filing deadlines and procedures can differ, you’ll typically file state and federal income taxes simultaneously to report all your income, credits and claim deductions.
There are different types of state and federal taxes depending on the source. Here are some examples.
Taxes levied on your income include the following.
The government levies these taxes based on what you own and include the following.
You pay taxes on the goods and services you buy, including the following.
The IRS oversees federal income taxes using the progressive system of marginal tax rates and brackets. In other words, you pay more taxes as your income increases. State income taxes use some federal tax principles when computing state income taxes. However, the tax rates, filing schedules, available deductions and credits may vary.
Like the IRS, some states use the progressive tax system with tax brackets and marginal rates, while others apply a flat rate to all taxable income. For example, Colorado residents pay a flat income tax of 4.4%.
A tax bracket is the range of income taxed at a given rate. Tax brackets typically differ depending on filing status and taxable income. At the federal level, the federal government divides taxable incomes into chunks and allocates a corresponding rate to each. These thresholds may change annually to reflect the inflation rate. States using the progressive system may have different tax brackets. For example, Colorado uses a flat income tax rate of 4.4% on taxable income.
Yes, the IRS and your state’s tax agency are different entities, so you’ll have to file and pay income taxes to each separately if you live in a taxpaying state. While some of the information on your state and federal income taxes may be the same, other taxes, credits and deductions may apply, depending on where you live.
Also, though you may be filing two separate returns received and processed by two distinct government agencies, the e-filing system may link them if you use the same online tax service for both. Generally, you’ll need to complete your federal tax returns before paying state taxes.
You remit and report your federal taxes to the IRS through a series of forms created by the U.S. Department of the Treasury. Primary among them is Form 1040, which collects your information and income and tax benefit activities for the year. Form 1040 varies depending on your activities in the previous year.
You may attach or submit extra forms if you have further information to provide. For example, if you want to claim itemized deductions, you must submit Schedule A to support your return. You may need additional forms for many tax credits.
In most cases, you must complete your federal income tax returns before preparing and filing your state return. There are many ways to do this. The IRS offers free filing of federal and state tax returns for specific categories of taxpayers. You may also qualify for Volunteer Income Tax Assistance, but the requirements are stricter. Tax Counseling for the Elderly also offers free tax return preparation services for people 59 and older.
You can either prepare and file your state income tax returns electronically or mail the paper forms to the state agency. Each state has tax forms, which you can obtain on the state’s online portal or a third-party website. For example, in Colorado, you’ll need Form 104 to file individual income tax returns.
Currently, eight states do not levy income taxes. These are Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming. New Hampshire does not tax earned income, but will continue levying taxes on interest and dividends through 2027. Let’s look at each in detail.
Alaska is one of the country’s tax-friendliest states. The state removed personal income taxes in 1980, instead taxing oil and gas production companies at higher rates. According to the Tax Foundation, Alaska has the lowest overall state and local tax burden, at 4.6%. However, the cost of living in Alaska is relatively high. Residents receive annual payments from the Alaska Permanent Fund Corporation, which was $3,284 in 2022.
The overall state and local tax burden in Florida is 9.1%. The state generates most of its tax revenue through sales and excise taxes, above the national average. Also, the cost of living is relatively high, with competitive housing and prices.
Nevada has an overall state and local tax burden of 9.6%. The state generates most tax revenue through excise, sin and sales taxes. The hospitality and tourism industries, including hotels and gaming establishments, generate revenue. Nevada’s overall cost of living is high, but property taxes are generally low.
Though South Dakota has no income tax, it generates revenue from other forms of taxation, such as excise and sin taxes. The overall state and local tax burden is 8.4%. Property tax rates are relatively high.
Tennessee levies higher sales taxes on items like alcohol, beer and fuel. Even fantasy sports contests attract a levy of 6%. However, the state’s overall tax burden is low, standing at 7.6%. Tennessee is a more affordable place to live than many other states
The second largest state in the U.S. after Alaska, Texas has an overall state and local tax burden of 8.6%. Sales and property taxes can be high in some jurisdictions, but the state is affordable with a low cost of living.
The least populated state in the country, Wyoming, relies on sales, excise and property taxes for income generation. The cost of living and housing is slightly above average. However, the overall state and local tax burden is low at 7.5%.
People and corporations in Washington are exempt from state income taxes. However, businesses are subject to business and occupation taxes, retail sales and use taxes and personal property taxes. The overall state and local tax burden is 10.7%, with a higher-than-average cost of living.
Technically, New Hampshire is not an income tax-free state — at least, not yet. The state still taxes interest and dividends on investment income at 5%, which will reduce annually until it completely phases out in 2027. The overall state and local tax burden is 9.6%.
You may need to file an income tax return in more than one state if you moved during the year or worked in two or more states. Things might get trickier if you live in one state and commute to another for work. If the two states have a reciprocal agreement, you may only have to file your income tax returns where you live. Also, some states have specific tax forms for full-time residents working in a reciprocal state.
Here are tips on how to reduce your taxes.
The law allows taxpayers to reduce their taxable income in several ways. Here are some examples.
Tax credits are legislative incentives that allow taxpayers to reduce the amount of taxes they owe. For example, a taxpayer eligible for a child tax credit can directly apply the credit to their actual tax liability rather than the taxable income, as done in the case of deductions. There are many types of tax credits, including the Lifetime Learning Credit, American Opportunity Tax Credit and Earned Income Tax Credits.
You can set up a health savings account for specific health care costs. It enables you to spend your tax-free money on qualified medical expenses. Instead of using other income sources, you can rely on your HSA.
BC Tax is a renowned tax consultancy firm with over 21 years of experience providing tailored solutions to clients nationwide. Our team of tax professionals offers a free, no-obligation consultation. Do you want to learn more about federal and state taxes or need help preparing and filing your returns? Contact us now!
Authored by the BC Tax Insights Team, this article reflects the collective expertise and experience of our seasoned tax professionals. The Insights Team at BC Tax comprises specialists with a deep understanding of various tax scenarios and solutions. With a focus on providing informative, accurate, and practical insights, our goal is to guide readers through the complexities of taxation and financial planning. Every piece is crafted with the intent to help individuals and businesses navigate the ever-evolving world of taxes, ensuring clarity and confidence in decision-making.
