Each state has its own tax code and its own rules and requirements. Some pretty much mirror the federal tax system, while others prefer to do things their way. This complicated web can lead to a lot of misconceptions for taxpayers when it comes to filing state returns, especially if you're working out of state.
Some common myths will cost you money, and others can get you into trouble with a state taxing authority. Here's the truth behind several misconceptions.
You Don't Only Have to Pay Tax in the State Where You Live
State income taxes apply not only to residents, but to nonresidents and part-year residents as well. Most states require that you pay taxes on income you earn while living there, as well as on income earned from sources within that state.
So if you live in Maine and cross over the state line into New Hampshire to work, you'll owe taxes to New Hampshire even though you don't live there. You might owe taxes to Maine, too, because you're a resident there—although not on the money you earned in New Hampshire.
The U.S. Supreme Court ruled in 2015 that two separate states can't both tax the same income—it has to be one or the other. So if you work in New York and you pay taxes there, Connecticut can't also tax you on that same income just because you live there.
State Income Tax Rules Aren't the Same as Federal Rules
Most state tax laws are similar to federal tax law, but each state usually differs from the federal rules in some respect. Some states choose to omit only certain parts of the Internal Revenue Code—which is the federal tax law—while other states omit nearly all of it.
Some states have even created a radically different income tax system that uses a flat rate for all taxpayers instead of bracketed tax rates like the IRS uses. This system applies the same percentage tax rate to all income.
Nine states have flat tax rate systems as of 2020: Colorado, Illinois, Indiana, Kentucky, Massachusetts, Michigan, North Carolina, Pennsylvania, and Utah.
State Income Taxes Aren't Unconstitutional
The Constitution does include clauses that prevent discriminatory taxes and state taxes that impede interstate commerce, but it does not ban state income taxes, or any other state taxes for that matter.
Occasionally, state tax laws will be challenged as unconstitutional, however. This happened in 2015 when the Supreme Court's made its ruling that two states cannot tax the same income.
Sections in a state's constitution can limit certain types of taxes, however. For example, a property tax was levied on businesses in Virginia to pay for subway expansion. One business challenged this tax, citing a section in Virginia's constitution that requires that all property in a taxable area be treated equally and uniformly. The business contended that this tax was unconstitutional because residential property owners didn't have to pay it, even though they would benefit from the subway expansion.
You Don't Have to Pay Income Taxes to Your Employer's State
Your employer's physical location or the location of its corporate headquarters has no bearing on your state income taxes unless you actually performed work in that state. If you live in Maine and work in Maine, but for a New Hampshire company with a satellite office in your state, you don't owe New Hampshire taxes because you're not performing work there.
If your employer accidentally withheld taxes for that other state, however, you would have to file a nonresident tax return there to receive a refund.
You Usually Don't Have to File a Return in a Reciprocal State
Some states have reciprocity agreements that exempt taxpayers from paying income taxes to the states where they work if they live in the other, but you must typically submit an exemption form to your employer to avoid any withholding of taxes from your pay in the state where you work. Each state has its own form. You'd still have to file a nonresident return to get those withholdings refunded if you didn't submit one.
As of 2020, the District of Columbia and 16 states have reciprocal agreements with others: Arizona, Illinois, Indiana, Iowa, Kentucky, Maryland, Michigan, Minnesota, Montana, New Jersey, North Dakota, Ohio, Pennsylvania, Virginia, West Virginia, and Wisconsin.
Your Audit Went Fine but You Might Still Have Made a Mistake
A state's primary objective in an audit is to find mistakes that might lead to you owing more tax dollars. If you failed to claim a deduction that you were entitled to, or if you qualified for a credit but didn't use it, it's your responsibility to find those errors yourself and file an amended return so you can get your money back.
An auditor will not be looking for these types of mistakes and usually won't volunteer the information if you goofed. It doesn't mean that you haven't overpaid your taxes just because you got a good report from your auditor. It just means that you haven't underpaid.
You Might Still Owe Taxes if You Work in a Tax-Free State
You can't avoid state income taxes simply by working in a tax-free state, you'd also have to be a resident there. If you don't happen to live in a state where there's no income tax, you'll have to pay tax to your home state on your income regardless of where you earned it.
For example, you might live in Georgia, but you work in Florida, which doesn't have a state income tax. As a resident of Georgia, you'd still owe taxes to that state on your income.
Seven states that do not tax income as of 2020: Alaska, Washington, Nevada, Wyoming, Texas, South Dakota, and Florida.
Likewise, you'd still have to pay taxes to the state where you worked if you're a resident of a tax-free state and you worked in a taxing state. Unless you're working in a reciprocal state, you'd have to pay taxes to the state where you earned your income and you would file a nonresident return there.