This is a question we get from clients relatively frequently, and the answer is that it depends on your situation. That said, there are a few high-level concepts that we can review that will clear up some of the confusion taxpayers often feel when dealing with this issue.
First, some key terms:
- Resident State – the state that you live in
- Non-Resident State – a state (other than your resident state) from which you have income
- Withholding – taxes withheld by your employer and paid to the government on your behalf (check out Why Do I Always Seem to Get a Tax Refund, and Do I Even Want One? for more about withholding)
How does a state determine how much tax I owe?
The tax you owe is based on your income and the state’s tax rate.
How does a state determine my income?
This is different for your Resident State and for your Non-Resident State(s):
- Resident State – Your resident state taxes you on all of your income, regardless of its source
- Non-Resident State – A non-resident state taxes you on your income sourced to that state
How do I know which state my income is sourced to?
Determining the source of income can vary based on the type of income in question, but in general, you can rely on these rules:
- Wages – Sourced to the state in which they are earned. This is usually an easy one, as your employer will break out your wages by state right on the W-2 that they give you at year-end. Your W-2 can include several states, and this is often the case for taxpayers who travel for work like consultants or professional athletes
- Business Income – This gets a little trickier, as states have different rules to determine whether business income is sourced to their state or not. Small business owners or self-employed taxpayers should work with their CPA to determine the proper sourcing of their income
- Certain types of income are almost always sourced exclusively to your Resident State
- Capital gains (except for gains from the sale of real estate located in a non-resident state)
- Gambling/lottery winnings
If my Resident State taxes all of my income, and a Non-Resident State taxes income sourced to it, doesn’t that mean that some of my income will be taxed in two states? That seems unfair…
At first glance, yes, your income is being taxed in two states, which is definitely unfair! However, the states are aware of this, and states that have an income tax generally also have a Resident Credit (although the name of the credit varies) to go along with it. A Resident Credit is a tax credit given to you by your Resident State to offset any taxes paid to a Non-Resident State. This is best explained by an example.
The Resident Credit, an example:
John lives in New Jersey and commutes into Manhattan every day for work. In addition to his salary, John has income from interest and dividends from his bank and brokerage accounts. John’s income is broken down as follows:
- Wages – $80,000
- Interest income – $3,000
- Dividend income – $7,000
When it comes time to file his tax return, John will have income sourced to both New Jersey and New York:
|New Jersey (John’s Resident State)||
New York (a Non-Resident State)
John will file both a New Jersey resident tax return and a New York non-resident tax return, and the income shown on each return will be per our table (above).
For the purposes of our example, let’s say that:
- New Jersey taxes income at 4%
- New York taxes income at 6%
- Note: these are not the actual tax rates, they are just nice numbers for our example
How much will John’s tax liability be to each state?
- New York tax = $80,000 x 6% = $4,800
- New Jersey tax (before we factor in the Resident Credit) = $90,000 x 4% = $3,600
- Total state tax (before the Resident Credit) = $4,800 + $3,600 = $8,400
However, now we have to figure out how much our NJ Resident Credit is and use it to decrease our New Jersey tax.
How is the Resident Credit determined?
While the specifics can vary from state to state, in general the Resident Credit is calculated as the smaller of these two amounts:
- The amount of tax paid to Non-Resident States
- The amount of tax your Resident State would have imposed on the income sourced to Non-Resident States
For John, the two possibilities are:
- $4,800. The amount of tax that John paid to New York
- $3,200. John needs to determine that tax that would have been paid to New Jersey on his New York-sourced income, which can be calculated as his NY-Source Income times the NJ tax rate
- Hypothetical NJ Tax on NY Income = $80,000 x 4% = $3,200
Because the NJ tax rate (in our example) is lower than the NY tax rate, NJ would only have imposed tax of $3,200 on the same $80,000 of income on which NY imposed tax of $4,800. This is an important limiting factor of the resident credit!
Now that we know both possibilities, we must use the smaller of the two as our Resident Credit, so for John, his Resident Credit on his NJ tax return for taxes paid to NY will be $3,200.
Where does this leave John?
Now that we know John’s NJ Resident Credit, we can determine his actual tax for each state:
New Jersey (John’s Resident State) – 4%
New York (a Non-Resident State) – 6%
|Calculated Tax (Income x Tax Rate)||3,600||4,800|
|Actual Tax (after credit)||400||4,800|
You may have noticed that John’s actual NJ tax of $400 is equal to his non-wage income of $10,000 (from interest and dividends) multiplied by the 4% NJ tax rate, which makes sense, because the Resident Credit effectively removed the NY-wage income from the NJ tax calculate, if in a somewhat roundabout way.
Now that I know this, how should I determine what to withhold for each state?
There are a few important factors that you should weigh when determining how much to withhold for each state:
- The tax rate for each state (reminder, the rates used in our example are not the actual tax rates for NY and NJ)
- How much income you will have from non-wage sources (e.g. interest and dividends)
- Are there any special rules that come into play for the states in question (e.g. NJ and PA have a special rule that removes the non-resident tax on wages for taxpayers living in one state and working in the other)
In general, if the tax rates of the two states are close (as is the case for the actual tax rates for NY and NJ) and your income is mostly from wages, you should withhold your full amount (based on your W-4, see Why Do I Always Seem to Get a Tax Refund, and Do I Even Want One? for more info) from the state in which you work, and very little (or nothing) in the state in which you live. However, you should note that you may end up owing a small balance at year end to your Resident State for tax on your non-wage income (e.g. interest and dividends).
Still doesn’t make sense? Not sure what the specifics are for your state or how they apply to your situation? Let us know, we can help determine the right setup for you!
Note: You may have noticed that, although John was working in Manhattan, we did not mention the NYC income tax. This was intentional, as the NYC income tax is a resident tax. Non-NYC residents are not subject to NYC income tax.
One Last Note: State taxes are an intricate and complicated topic, and this post was intended to provide a high-level overview of the Resident Credit and how to approach your taxes when you live in one state and work in another. You should consult your tax advisor before making any decisions regarding your own tax situation.