The Basics of US State Tax Residency

Tax residency is like financial turducken, or maybe a corndog. It seems a certain way on the surface, but there’s some stuff within that will surprise you, and it’s worth doing some research ahead of time so you know what you’re about to bite into. To understand why tax residency matters, we have to understand how state income tax works. State income tax rates receive far less attention than federal income taxes, but they can still have a big impact on your finances (good, and bad). It all comes down to your income, types of income, where you live, and where you work. Here are some of the  details as well as a list of states without an income tax. 

How do states earn revenue? 

Let’s start with a basic primer on how state governments earn revenue to pay for basic services.  Typically the bulk of state revenue comes from property and income taxes, along with sales tax or excise taxes (think gas, tobacco, alcohol). Other possible sources include business taxes, or federal funding.

What is state income tax, and how do their tax rates work?

Like federal income tax, a state income tax is a tax levied by a state on income earned there. 

In general, states take one of three approaches to taxing residents and/or workers: 

• No income tax at all. 
• Flat tax. That means they tax all income, or dividends and interest only in some cases, at the same rate. 
• Progressive tax. That means people with higher taxable incomes pay higher state income tax rates. 

States with no income tax

Any state with an absence of income taxes is looking to woo folks to move there as a means to generate population growth, and in turn, stimulate the economy. Eight states don’t have an income tax: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming. New Hampshire has a 5% tax on dividends and interest only. But! Before you get the urge to throw everything in a U-Haul and head for a state with no income tax, keep in mind that these states are looking to make up for that revenue loss by raising rates on other things such as property, fuel, and sales taxes. The math can mean that higher costs elsewhere can cut into your income tax savings. 

States with flat income tax rates 

Ten states try to keep things simple by applying the same tax rate to most income. Of course, what counts as “income” depends on the state. In New Hampshire, for example, regular income is generally not subject to state income tax, but a flat tax rate applies to dividends and interest income. And some states apply their tax rates to taxable income, while others use adjusted gross income. 

• Colorado - 4.55% 
• Illinois - 4.95% 
• Indiana - 3.23% 
• Kentucky - 5% 
• Massachusetts - 5% 
• Michigan - 4.25% 
• New Hampshire - 5% 
• North Carolina - 4.99% 
• Pennsylvania - 3.07% 
• Utah - 4.95% 

States with progressive tax structures 

Most states and the District of Columbia tax income much the way the federal government does: they tax higher levels of income at higher state income tax rates.  State income tax rates tend to be lower than federal tax rates. Many range between 1% and 10%. Some states tax as little as 0% on the first few thousand dollars of income.  High-tax states top out around 13%, and that’s often on top of property taxes, sales taxes, utility taxes, fuel taxes and whatever the taxpayer must send to the federal government.  Please refer to this link for the detailed tax rates of each state. 

2022 state taxes 

To learn more about how your state income tax rates work, visit the website of your state’s taxation and revenue department, or the Federation of Tax Administrators 

Who do you owe taxes to? 

Each state handles taxes differently, but understanding your residence versus your “domicile” is an important concept.  You can own a residence in more than one state. But are generally only a resident for state income tax purposes when your “domicile” is within that state, and you spend more than half of the year living there. For income tax purposes, the term “domicile” means that a resident considers a state to be their permanent place of legal residency, “true home” or the place they return to after being away. You must be physically in the same state as your domicile most of the year, and able to prove it’s your principal residence with compelling proof that you live and invest in the state. Tax authorities want more than just a mailing address or driver’s license; you’ll need to track time spent at the domicile compared to your other residence(s). Take a look at the Chrono app to address this.

As an example, let’s say a long-time Minnesota couple purchased a second home in Florida to use three months of the year. Since the couple spends most of the year in Minnesota, it’s their domicile. They have a residence in Florida. If audited, tax authorities could investigate where the Minnesotans earn income, where their children attend school, and where they belong to clubs or religious intuitions to help determine domicile. 

Do I Need to File State Returns In Two States? 

If, like most people, you live and work in the same state, you probably need to file only one state return each year. But, you may need to file more than one if: 1) you moved to another state during the year, 2) you live in one state but worked in another, or 3) you own income-producing rental properties in multiple states. Lastly, because the price of most tax software packages includes preparation and filing for only one state, if you need to instead file in multiple states, you’ll likely be paying extra for tax preparation software. 

183-day rule 

Your physical presence in a state plays an important role in determining your residency status. Often, spending over half a year, or more than 183 days, in a particular state will render you a statutory resident and could make you liable for taxes in that state.  See here for more info on 183 days here.

When in doubt… 

As with many financial decisions, determining your state residency tax-filing status and tax liability can be complicated. Consult a tax professional to help you examine your specific situation and guide you on how to best handle, and minimize, your taxes for the current year and in the future.