The Internal Revenue Service isn't the only taxing authority that's holding its hand out for a piece of your paycheck. Most states—41 in all—impose a broad-based individual income tax. Only eight states lack an income tax altogether: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. While Tennessee previously taxed on investment income and interest, titled the Hall Income Tax, was fully repealed on Jan. 1, 2021.
New Hampshire falls into a gray area, as it collects taxes on dividend and interest income, but not earned income.
Why Do Some States Not Have an Income Tax?
State income tax is set at the state level, not the federal level, so it's entirely up to state lawmakers. Their reasons for not having income taxes could be driven by their ideals for tax policy, as an incentive to attract new residents, or due to an increase in revenue from another source.
The state income tax was repealed after an oil boom in the 1970s in Alaska. The overwhelming majority of Alaska's revenue comes from oil industry activity in the state. Alaska decided that it could receive most of the revenue it needed from the oil industry, so the state no longer needed to tax residents' incomes.
Tennessee and New Hampshire Income Tax
Tennessee gradually reduced its "Hall tax" on interest and dividend income. The state's 6% Hall tax rate was reduced by 1% increments each year until the tax was eliminated as of January 1, 2021. The Hall tax rate was just 1% in tax year 2020.
Alaska, Tennessee, and New Hampshire are the only states to ever take legislative steps to eliminate an existing income tax.
New Hampshire assesses a 5% tax on interest and dividend income beyond $2,400, as of 2021. Interest and dividend income aren't taxed for married couples filing joint returns until that amount exceeds $4,800. An additional $1,200 exemption is available for certain taxpayers who are disabled, blind, or over the age of 65.
The tax on interest and dividends is currently being phased out over a five-year period, following the signing of a bill in 2018. New Hampshire will officially have no income tax by 2024.
What if You Earn Income in Other States?
You must still report income earned in other states on your home state tax return if you live in a state that does levy an income tax, even if that income is earned in one of the tax-free states. It works both ways—if you live in a tax-free state and earn income in a state that does tax earnings, you must file a non-resident return in that state, even though you don't live there.
Taxes on Retirement Income
Thirty-seven states and the District of Columbia take it easy on retirees when it comes to taxes. Many seniors in these states don't pay income tax, at least when they stop working. Some of these states exclude all retirement income, while others exempt only a portion.
Other states have either partial exemptions or full exemptions for people who meet certain income requirements. For example, Kansas exempts Social Security income if your adjusted gross income from all sources is $75,000 or less.
Some states don't tax government pensions. Depending on your state, you may have to pay income tax if you earned a government pension elsewhere but moved to one of these states when you retired.
Pennsylvania also exempts private-sector pension income, and Alabama doesn't tax income from defined-benefit retirement plans. Hawaii doesn't tax income from contributory retirement plans.
Other Taxes in These States
Before you plant a "For Sale" sign on your lawn and begin packing your bags to move to one of these tax-free states, keep in mind that they still have to raise revenue to function. That means they have to get their money from somewhere.
States without an income tax often make up for the lack of these revenues by raising a variety of other taxes, including property taxes, sales taxes, and fuel taxes. These can add up so you're paying more in overall taxation than you might have in a state that does tax your income at a reasonable rate.
New Hampshire and Texas have some of the highest average property taxes per capita in the nation, although New Hampshire doesn't have a sales tax. Tennessee has one of the highest sales tax rates in the U.S. Washington will get you at the gas pump with a combined federal and state gas tax of nearly $0.68 per gallon.
States in the Northeast and along the West Coast also have higher-than-average costs of living that should be taken into account, too.
The Effect on Your Federal Tax Return
It used to be that you could claim a tax deduction for state income taxes you paid if you itemized on your federal return, and you can still do that ... sort of. The Tax Cuts and Jobs Act (TCJA) capped this deduction at $10,000 when it went into effect in 2018, and this $10,000 limit includes property taxes as well.
Those who don't have to pay income tax might be able to deduct most or all of their property taxes on their federal returns.
The Bottom Line
Spending habits and lifestyles can vary dramatically, and so do the taxes that families face. You might not have to worry about higher property taxes if you don't plan on owning a home. You should understand all the quirks to local tax law before you can truly compare your potential tax burden in different states.
Frequently Asked Questions (FAQs)
What is income tax?
Income tax is one of the ways governments raise funds. Governments impose a tax on income earned by individuals and businesses. The funds raised are used for government programs, including public services, schools, roads, and programs like Social Security.
What is the income tax rate?
The federal income tax is a progressive tax, which means that the more income you earn, the more you're taxed. The tax rate is divided into brackets, and you pay taxes based on the brackets your income falls into. For example, the 2021 tax brackets are 10%, 12%, 22%, 24%, 32%, 35%, and 37%. If your taxable income was $41,000 in 2021 and you're a single filer, you would pay 10% on your income up to $9,950, 12% on $9,951 to $40,525 in income, and 22% on your income up to $41,000.