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10 Smart State Income-Tax Saving Strategies

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You can’t do serious tax planning unless you take state and local taxes into account, too.  States and municipalities, forced by Congress to shoulder more and more of the burden of social programs, have been hiking levies dramatically in recent years.  The result?  State and local taxes can no longer be ignored.  Fortunately, you can fight back.  In some cases you can do so just by making the federal income-tax-saving moves previously mentioned.  Most states exact a percentage of what you pay to the feds or use your federal return as a starting point in computing your state tax.  Lower your federal tax and you then automatically chip away at your state tax, too.

That’s just the first step, though.  Now comes the hard part: sifting through your state’s tax code for any odd twists and turns you can exploit.  For instance, some expenses that aren’t federally deductible are allowed as write-offs by many states.  A few examples are political contributions, a portion of your rent, and medical expenses that fall below the federal deductibility threshold of 7.5% of adjusted gross income.  Some states also offer their own tax credits not available from the federal government, such as a renter’s credit in Hawaii and, in several states, credits for installing energy-saving equipment.  Ask your tax pro or consult a state tax handbook, available in most libraries, for a listing of your state’s deductions, exemptions, and credits.

Here are ten ways to fight back against steep state taxes:

1.  Invest in municipal bonds. Most municipal bonds issued by your state pay interest that is exempt from federal, state, and local taxes.  This can be especially valuable in states that tax interest at a high rate such as California, Connecticut, and New York.  For instance, a California couple in the 36% federal bracket and the 9.3% state bracket who buy municipals yielding 6% would have to find a taxable investment paying 10.97% to make as much money after tax.

2.  Buy Treasury securities. Not only are they the safest investments, their interest is exempt from state and local taxes.  That lets you pocket up to seven-tenths of a percentage point in extra yield if you live in a high-tax state.  For the same reason, look at money-market funds that hold Treasuries; such funds offer yields very close to those on the best-performing nongovernment money funds.  After taxes, however, the government money funds pay nearly a point more in high-tax states.  Caution:  The words “U.S. Government” in a mutual fund name don’t necessarily mean all of its earnings are tax-free in your state.  For example, many states tax interest earned on U.S. government-backed mortgage securities known as Ginnie Maes.  The fund will usually enclose a list with its year-end statement, showing the percentage of its income that is exempt from tax in your state.

3.  Don’t pay tax on tax-exempt income. Social Security benefits are fully exempt from state taxes in California, Illinois, New York, Pennsylvania, and 22 other states.  Pension income is also exempted, or at least partially exempted, in 16 states.  The pensions of specific employees (usually military personnel) are not taxed in 14 states.  Lottery winnings –you should be so lucky –are also tax-free in many states.

4.  Benefit from favored capital-gains treatment. Four states currently protect a percentage of capital gains:  Kentucky (60%), Maryland (30%), Massachusetts (50%), and Wisconsin (60%).

5.  Take full advantage of your federal deductions for state and local taxes. If you itemize deductions on your federal return, remember to write off the state and local income tax withholding shown on your Form W-2, as well as your real estate tax and any personal property tax.  Don’t overlook such items as the state estimated tax payment for the previous year that you made last January and taxes for a prior year that you paid as a result of an audit or because you filed an amended or late return.  State disability insurance withheld in California, New Jersey, New York, and Rhode Island is also deductible.  Finally, ask your tax adviser or local tax agency what local charges, such as water or sewage fees, may be federally deductible.

6.  Know where your state is stricter than the feds. Don’t assume that the federal rules automatically apply to your state.  Among the snares:  10 states and the District of Columbia will not grant a extension for filing your state income tax return simply because you requested a federal extension.  Also, the estimated tax penalty may be different in your state from the one the feds use.  Under federal law, if you make estimated tax payments (quarterly taxes due if you don’t have enough withheld) and underpay your federal liability by $1,000, you’re hit with a tax penalty.  The cutoff can be much lower at the state level, however.  The feds say that you must make quarterly estimated tax payments to the IRS if you expect to come up with a tax due of $1,000 or more at the end of the year and your withholding won’t cover 90% of your tax or 100% of last year’s tax, whichever is less.

7.  See whether it pays to file separate state returns for you and your spouse. To ease the tax bite on two-earner couples, 11 states let married persons file separately, even if they file a joint federal return.

8.  Research the taxes of a locale before you move. Don’t jump from the frying pan into the tax fire.  For example, only the District of Columbia and five states exempt interest on out-of-state municipal bonds from income tax:  Indiana, New Mexico, and Utah and, in certain cases, North Dakota and Vermont.  A full 20 states refuse you the right to special five or ten-year averaging on lump-sum distributions (for more on the advantage of averaging pension distributions, see “How to Retire Comfortably’).  But six states (Hawaii, Illinois, Louisiana, Michigan, Missouri, and West Virginia) don’t tax lump-sum distribution at all if you elect special averaging on your federal return.

9.  Plan your state. Half the states impose estate or inheritance taxes independent of federal estate taxes.  The result:  Even a modest estate may be exposed to death taxes.  Consult an estate-planning lawyer for ways to reduce or eliminate death duties through charitable gifts, trusts, and other strategies.

10.  Move to a no- or low-tax state. If you are blessed with economic freedom of choice, you can always take tax flight.  Six states have no income tax at all.  They are Alaska, Wyoming, South Dakota, Nevada, Texas, and Washington.  Florida has no personal income tax but does levy an annual .1% wealth tax on portfolios above $20,000.  New Hampshire and Tennessee impose a flat tax on interest and dividends only.  Other states that take a smallish income tax bite include Alabama, Delaware, Louisiana, Mississippi, Missouri, New Mexico, and North Dakota.

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