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Federal vs. State Income Tax

When it comes to paying your annual tax, you want to make sure you’re on the right side of the rules. The multi-tiered US tax system can sometimes make it difficult to understand exactly what proportion of your yearly income is taxable. However, understanding what state and federal taxes you need to pay will help you to avoid any penalties or fines and ensure you’re making the right level of contribution to government services and infrastructure. This guide will explain the differences between federal vs. state income tax as well as their rates and definitions, starting with what state income tax is.

What is state income tax?

State taxes, including state income tax, are collected by individual state governments to pay for state projects and costs, such as local infrastructure, roads, and community services. If you earn money or live in a particular state, then you will have to pay the income tax rates for that state. Earners need to file a tax return in any state where they’ve earned money and will be taxed on all of their income in the state where they live.

Every state has its own unique state income tax rates and system. Seven states don’t have any income tax rate and two (Tennessee and New Hampshire) only tax unearned income. Nine states, including Colorado, Illinois and North Carolina, have a flat-rate system which means that all income levels are taxed at the same rate. The other 35 states and the District of Columbia have a progressive tax system that includes different tax rate brackets depending on your level of income, so the more you earn, the higher percentage of tax you pay. These brackets are different in each state and are often adjusted to match rates of inflation.

What is federal income tax?

Federal income tax is set by the Internal Revenue Service (IRS) and is paid by taxpayers, businesses, corporations, trusts and other legal entities. This tax rate is applied to all their taxable income, including wages, capital gains and other assets, like crypto.

US federal income tax is applied via a progressive tax system with seven different brackets. For the 2021 tax year, the lowest tax rate of 10% is applied to anyone earning up to $9,950 as a single person, or $19,900 for a married couple jointly filing their tax return. The highest rate of 37% is applied to anyone earning $523,600 as a single person or $628,300 for a jointly filing married couple. In order to pay a lower tax rate, it’s also possible to claim the standard deduction set by the government or itemize deductions that subtract designated expenses from taxable income.  

Key differences between state and federal tax

One of the main differences between federal vs. state income tax is that the rates are set by federal and state governments respectively. This means that income tax rates vary considerably from state to state and for different income brackets. Plus, the types of income that are taxed are different under federal and state rules and between different states. Income from certain types of securities, for example savings bonds, aren’t taxed on a state level but will be taken into account in your federal tax return.

The other main difference between the two types of income tax is where and how the tax contributions are used. State-level income tax is used to put towards running local services, such as education and the police, and improving or developing local roads, highways and public buildings. In contrast, US federal income tax contributions are used to fund projects that help to maintain and grow the country. It’s a large source of revenue for the government and is used to cover a wide range of expenses, from infrastructure to public transportation and disaster relief.

Paying state and federal income tax

When it comes to paying your federal and state income tax, you need to ask yourself a few questions:

  • What federal income tax bracket do I sit within?

  • Have I earned money in several different states?

  • What is the tax rate and system for my home state?

  • What are the federal and state income tax rates for my income bracket?

  • Are there any other assets that could be subject to state and federal taxes?

  • Is it possible for me to claim a standard deduction or itemized deductions?

All of these questions will help you to narrow down the income tax brackets you fall into and ensure you’re filling in your tax return accurately.

If you’re unsure about how to file your tax returns or have any questions around how much tax you’re liable to pay on your level of income, it may be worth getting an accountant to help you. This will give you the reassurance to know you’ve made the correct contribution and won’t face any penalties or fines later down the line.

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