In the United States, federal income tax is just the start. In most cases, you also have to pay state tax, and some municipalities charge local or city income tax as well. All those bills can add up, and you may be wondering “how can I avoid state income tax?” or “can I lower my state tax bill?”
In most cases, you have to pay state income tax based on where you live, but the issue is a bit more nuanced than that. Here’s what you need to know.
How Much Is State Income Tax?
State income tax varies widely. The highest state income tax rates are 13.3% in California, 9.9% in Oregon, and 9.85% in Minnesota, but those rates only apply to the highest income brackets. For instance, in California, taxpayers only face that rate on taxable income over the million dollar mark.
There are seven states with absolutely no state income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. New Hampshire and Tennessee don’t charge state income tax on earned income, but they do assess income tax on dividends and investment income. By 2022, Tennessee plans to phase out this tax and join the list of states with no income tax.
How Much Do You Save by Moving to a State With No Income Tax?
If you live in a state with high-income tax and you move to a state with low-income tax, you can save a lot of money. For instance, if you live in California and you have $1,500,000 in taxable income, your state income tax bill comes out to approximately $175,921. If you move to Nevada, Texas, or one of the other states without income tax, that money goes straight back into your pocket.
Even on the lower end of the earning scale, you can save a significant amount. A taxpayer in California with $50,000 in taxable income pays $4,650 in state income tax. Colorado has a flat state income tax of 4.63%, and someone with $50,000 in taxable income pays $2,315. Moving to any of the states with no income tax eliminates these bills. A move like that could save you $193 to $387 per month.
Who Has to Pay State Income Tax?
Generally, states with income tax assess tax on the people who work and live in those states. Most states define residency based on where you are domiciled. You can only have one domicile at a time. If you are domiciled in a state, you pay tax on all your income to that state, but if you are domiciled somewhere else, you only pay tax on income earned in that state.
For instance, imagine that you live the majority of the year in Florida but for six weeks of every year, you travel to Colorado where you live in your holiday home and work part-time at a ski resort. In this case, you will likely pay Colorado state income tax on those earnings but not on any other earnings. However, as you are domiciled in Florida, which doesn’t have state income tax, you don’t have to pay state income tax on the rest of your earnings.
Most states have laws in place so that double taxation does not exist. Note that if you are domiciled in a state with income tax but you earn money in another state that also has state income tax, you usually don’t have to pay double tax. Generally, a taxpayer receives a credit for taxes paid to a state they work in with a state income tax. For example, if you work in New York but live in Connecticut, you will pay NYS taxes. However, you will receive a credit from CT for taxes paid to NYS. In this situation, the taxpayer will need to file a nonresident NYS tax return as well as a CT state income tax return.
Reciprocal Tax Agreements
Some states do have reciprocal tax agreements (RTA) for those individuals that live in one state but work in another. The benefit of RTAs is that a taxpayer doesn’t have to file tax returns for two states. The RTAs simplify the tax preparation for taxpayers and allow taxpayers to be taxed in the state they live in.
Can You Change Your Domicile to Avoid State Income Tax?
The issue of where you are domiciled can get murky especially if you have homes in multiple states or if you travel a lot. In these cases, you probably want to ensure you are domiciled in the state with the lowest tax rate.
Domicile mostly boils down to intent. Which state do you intend to make your permanent home? However, “intent,” is a state of mind which is hard to prove.
To backup your intent, you need an address in the state where you want to be domiciled. Ideally, you should put that address on your federal income tax return, vehicle registration, financial accounts, and Social Security registration forms. You may also want to get a driver’s license, register to vote, and open a bank account in that state. Social connections such as library cards, gym memberships, and even doctor and dentist appointments can also help.
If you are trying to switch from being domiciled in one state to another, you should take these steps in reverse in your old state. To that end, sell or rent out your house. If you have to file an income tax return in that state, file as if you are a non-resident. Cancel memberships, change your address on bank statements, and stop seeing doctors, lawyers, accountants, and other professionals in that area.
Do Full-Time Travelers Have to Pay State Income Tax?
If you’re a full-time traveler, a retired RVer, or someone in a similar nomadic situation, you have some flexibility when it comes to setting up your domicile. However, it’s important to note that domicile doesn’t just refer to where you are, it refers to where you plan to return.
A classic example is a college student who lives nine months of the year in the state of their college and only returns “home” for the summer. Although they only spend three months of the year in their home state, it is likely still considered their domicile.
Some states are very welcoming to full-time travelers who want to set up a domicile there. For instance, SD lets travelers complete a residency affidavit. The short affidavit features just two questions: 1) Are you a resident of South Dakota? 2) Do you plan to return to South Dakota?
That particular state residency affidavit also requires proof of temporary address, but the state accepts receipts from hotels and RV parks. After filing that form with the state, travelers tend to solidify their residency by getting a local driver’s license, vehicle registration, voter registrar, and by meeting with professionals (doctors, lawyers, etc.) in the area, as explained above.
If a full-time traveler sets up residence or domicile in a state like South Dakota, they don’t have to worry about state income tax. However, there may be situations where the department of revenue in their previous home state comes looking for them.
Can You Get in Trouble for Not Paying State Income Tax?
Of course. If you are supposed to pay income tax in a state and you don’t, you can face a range of penalties, interest, and fines in addition to your state tax bill. There’s no statute of limitations on this. With most tax matters, the statute of limitations starts when you file an income tax return. If you don’t file a return, the clock never starts in most cases, and the state could basically come after you at any time.
There are certain red flags that most states look for. If you have income sourced in a certain state but you file as a non-resident, the state may take a closer look at your situation. If it determines that you are indeed a resident, you may have to pay state income tax on all your income, regardless of where it’s sourced.
Gaps in filing also raise a red flag. If you file as a resident for several years, don’t file for a few, and then file again, the state may look a little deeper into what you have been doing in the meantime.
Are State Income Tax Rules Different for Trusts?
If you set up a trust, the rules are a bit different than they are for earned income, but in general, states tend to assess income tax on trusts if the trusts are residents of the state. To determine this, most states take into account the following four factors: the grantor’s state of residence, where the trustees and beneficiaries live, and where the assets are held.
Additionally, most states require trusts to pay state income tax on income sourced from that state. This is true regardless of whether or not the trust is considered a resident. This overlaps with the rules faced by people who work temporarily in one state while residing in another. For instance, if a trust resides in Wyoming but collects some rental income from New York, it may need to pay New York State income tax on that rental income.
How Do You Avoid State Income Tax on Trusts?
To avoid state income tax on income earned by trusts, many people are setting up trusts in states with generous laws. South Dakota, in particular, has attracted many people who are trying to avoid state income tax. As of 2015, the state hosted $175 billion in trust assets. That’s almost four times the state’s gross domestic product for the same year.
People are setting up their trusts in this state because there is no state tax on income, capital gains, dividends, or intangible taxes. The state also has very low insurance premiums, and it allows trusts to endure indefinitely which helps these people to avoid estate tax.
If you are trying to avoid state income tax, it is possible. However, you may have to move or embrace a nomadic lifestyle. Unfortunately, in many cases, even if you move abroad or travel for a few years, you may be still be considered domiciled in your home state and owe taxes for the years you weren’t a resident. To avoid that, it’s critical to ensure that you do everything above board and consult with a tax professional about the laws in your state.