State Income Tax vs. Federal Income Tax: An Overview

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 tax rate to taxable incomes, but they can differ considerably with respect to those tax rates and how they're applied, as well as to the types of incomes that are taxable, and the deductions and tax credits that are allowed.

State Income Taxes

State income tax rates can vary considerably from state to state. In fact, Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming have no income tax at all. New Hampshire and Tennessee tax only interest income and dividends, not earned income from salary and wages, and Tennessee is in the process of repealing even this taxation by 2022.

All other states have either flat or progressive income tax systems. A flat system is a single rate that applies to all levels of income. Eight states use this system as of 2019: North Carolina (5.499%), Massachusetts (5.10%), Utah (5%), Colorado (4.63%), Michigan (4.25%) Illinois (3.75%), Indiana (3.23%), and Pennsylvania (3.07%).

Thirty-three states tax according to marginal, progressive systems where higher levels of income are taxed at a greater percentage, a commonality shared with the federal income tax system. Each "bracket" of income is taxed at a higher percentage. Some states base their brackets on the federal tax code, but many states implement their own. Some adjust their brackets annually to keep pace with inflation, but others do not.

Hawaii has 12 tax brackets as of 2019, while Kansas only imposes two. California's progressive tax system has the highest top tax rate of 13.3% on incomes above $1 million, followed by Hawaii at 11%. North Dakota (2.9%) and Arizona (4.54%) are among the states with the lowest top tax rates.

Federal Income Tax

The Internal Revenue Code (IRC) governs federal income tax in the U.S., and the IRC underwent some significant changes in 2018 with the passage of the Tax Cuts and Jobs Act (TCJA). But the U.S. continues to implement a progressive tax system. There are seven tax seven brackets and marginal tax rates at the federal level: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The top rate of 37% is significantly more than California's 13.3%, and it kicks in at only $510,300 in taxable income, whereas California's high rate doesn't apply until a taxpayer has more than $1 million in taxable income.

[Important: The federal government annually adjusts various tax breaks and tax brackets for inflation.]

Special Considerations

The federal tax system allows taxpayers to claim a standard deduction, or they can itemize their deductions, but they can't do both. Standard deductions increased considerably in 2018 under the TCJA. As of 2019, they're set at $12,200 for single taxpayers, $18,350 for head of household filers, and $24,400 for married taxpayers filing joint returns.

Retirement income is fully taxable by federal tax authorities, while a number of states partially or fully exempt retirement income from taxation. There are differences with respect to taxing bond interest as well. For example, interest received on U.S. savings bonds is subject to federal taxation, but it's exempt from state tax.

There are also differences with respect to tax credits. For example, the state of New York allows a tax credit based on 20% of premiums paid for long-term care insurance, while federal laws disallow such tax credits. Federal law allows several other credits, however, such as for education expenses, retirement savings, and dependent care expenses. The IRC also provides for an earned income tax credit, and 29 states plus the District of Columbia offer their own versions of this credit, as well.

State Income Tax vs. Federal Income Tax Example

A single taxpayer who lives in New Hampshire has taxable earned income of $75,000 a year and interest income of $3,000 annually. He pays $150 in state taxes because New Hampshire does not tax earned income, but it taxes unearned income at the rate of 5% as of 2019. His effective state tax rate (tax debt divided by taxable income) would be .003%.

He pays federal taxes of $970 on the first $9,700 of his income, which falls into the 10% tax bracket. He pays 12% on his income from $9,701 to $39,475 ($3,573) and 22% on the balance ($8,475.50) for a total federal tax bill of $13,018.50. His federal taxable income includes his interest income. He has an effective federal tax rate of 16.6%.

At a taxable income $78,000, including both earned and interest income, the same taxpayer would be subject to the second highest tax rate of 6.37% if he lived in New Jersey. This state taxes both earned and unearned income. His total state tax bill would be $2,844.10 at this state's graduating, progressive rates: $280 on the first $20,000, $262.50 on his income from $20,001 to $35,000, $175.00 on his income from $35,000 to $40,000, $1935.50 on his income from $40,000 to $75,000, and $191.10 on the balance of $3,000. His effective state tax rate in New Jersey is .03%. His federal tax bill would remain the same at $13,018.50.

Key Takeaways

  • There are no uniform rules for state income taxes and brackets and breaks. Tax rates can vary considerably from one state to the next.
  • Seven states do not have an income tax at all, and another is in the process of repealing its tax by 2022.
  • The federal government imposes the same progressive tax system on all citizens.