The United States has a multi-tiered income tax system under which taxes are imposed by federal, state, and sometimes local governments. Federal and state income taxes are similar in that they apply a percentage rate to taxable incomes, but they can differ considerably with respect to those rates and how they're applied, as well as to the type of income that is taxable and the deductions and tax credits that are allowed.
- The federal government and the majority of states have income taxes, but their rules and rates can vary widely.
- Federal taxes are progressive, with higher rates of tax on higher levels of income.
- Some states have a progressive tax system, while others impose a flat tax rate on all income.
State Income Taxes
State income taxes can vary considerably from one state to another. In fact, Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming have no income tax at all. New Hampshire taxes only interest income and dividends—not earned income from salary and wages—but is in the process of repealing this tax through a gradual phase-out over five years, with completion set for January 2024. (Tennessee, like New Hampshire, used to tax interest income and dividends, but it completed a phase-out as of Jan. 1, 2021.)
All the other states have either flat or progressive income tax systems. A flat tax system is one that applies a single rate to all levels of income. Eight states use this method as of 2021: Colorado (4.55%), Indiana (3.23%), Kentucky (5%), Massachusetts (5%), Michigan (4.25%), North Carolina (5.25%), Pennsylvania (3.07%), and Utah (4.95%).
Most states that impose income taxes, however, use progressive tax systems, where higher levels of income are taxed at a greater percentage rate, as is the case with the federal income tax system. Some states base their marginal tax brackets for this purpose on the federal tax code, but many states implement their own. Some adjust their brackets annually to keep pace with inflation, as the federal government does, while others do not.
Hawaii has 12 tax brackets as of 2021, while Kansas has only three. California's progressive tax system has the highest top tax rate of 13.3%, which applies to singles with taxable incomes over $1 million and married couples with incomes over $1,181,484. North Dakota, at 2.9%—which applies to singles or married couples with incomes over $433,200—has the lowest top marginal tax rate.
Some states tax pension and Social Security income, while others do not.
Federal Income Tax
The U.S. Internal Revenue Code, which spells out the federal income tax rules, underwent some significant changes in 2018 with the passage of the Tax Cuts and Jobs Act (TCJA). There are now seven marginal tax brackets at the federal level: 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
For the 2020 tax year, the top rate of 37% kicks in at $518,401 in taxable income for singles and $622,051 in income for married couples filing jointly. For the 2021 tax year, the top rate of 37% kicks in at $523,601 for singles and $628,301 for married couples filing jointly.
Under the federal tax system, taxpayers can claim either a standard deduction or itemize their deductions. Standard deductions increased considerably in 2018 under the TCJA, making it more advantageous for many taxpayers simply to take the standard deduction. For the 2020 tax year, the standard deduction is $12,400 for single taxpayers and those married filing separately, $18,650 for head of household filers, and $24,800 for married couples filing jointly. For the 2021 tax year, the standard deduction is increasing to $12,550 for single taxpayers and those married filing separately, $18,800 for head of household, and $25,100 for married filing jointly.
As mentioned above, states and the federal government differ in terms of the types of income they tax and the deductions and credits they allow. Pension and Social Security income, for example, are taxable under the federal rules, while a number of states exempt it from taxation. Income from U.S. Treasury securities, including savings bonds, is exempt from state tax, but subject to federal taxes.
State Income Tax vs. Federal Income Tax Example
Consider a single taxpayer who lives in New Hampshire and reports a taxable earned income of $75,000 a year plus interest income of $3,000 on their federal tax return. New Hampshire has a $2,400 tax exemption for the interest and dividends tax, so tax is only due on the remaining $600 ($3,000 - $2,400) of interest and dividends income.
The taxpayer would, therefore, pay just $30 ($600 * .05) in state taxes because New Hampshire doesn't tax earned income but does tax investment income, over the exemption amount, at the rate of 5%. This individual's effective state tax rate on their total income of $78,000 (tax obligation divided by taxable income) would be 0.038%.
If this same person lived in Utah, however, all of their taxable income, both earned and unearned, would be subject to that state's 4.95% flat tax rate. In that case, their tax bill would be $3,861 ($78,000 * .0495).
In terms of federal taxes, in 2021, under the progressive system, this taxpayer would pay $995 on the first $9,950 of their income, which falls into the 10% tax bracket. They'd pay 12% on their income from $9,950 to $40,526 ($3,669.12) and 22% on the amount greater than $40,526 ($7,584.28) for a total federal tax bill of $12,248.40. Their effective federal tax rate would be 16.3%.