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Tax Planning

State and Local Taxes Affect Your Wallet

There are other types of taxes besides income tax. We’ll walk you through common types of state and local taxes, and provide tips on how you can minimize your tax liability so that you can keep more money in your wallet.

Articles by Eric Bronnenkant

By Eric Bronnenkant
Head of Tax, Betterment  |  Published: April 29, 2019

Long before I started working in the tax profession, I had my first experience with state and local taxes as a young child. While at the grocery store with my mother, I wanted a pack of gum. It was advertised as $1.00 and I felt pretty energized about persuading my mother to give me a one dollar bill to pay for it.

Once at the register, I found out that with the 7% state sales tax in New Jersey at the time, the actual price came to $1.07—and I came up short.

Smart investing can help you minimize your tax liability.

First, let’s define some of the various types of state and local taxes that you will face.

  • Income tax: Tax that is paid to the state or local authority based on income such as wages, business profits, interest, dividends, capital gains, etc. Wage income is typically subject to tax withholding at the time it is received (and reconciled through annual filing). In contrast, taxes on investment income are typically paid through quarterly estimated payments or at the time of annual filing.
  • Sales tax: Tax that is paid to a local authority on goods and services, typically at the time of the sale. In some states, there may be an exemption for basic necessities such as medicine, food, or clothes. New York City has a sales tax rate of 8.875%, which  is one of the highest in the nation.
    • Sales tax can be funny sometimes. For example, New York does not tax unprepared food like a whole bagel, but one that is sliced for you is taxed.
  • Real estate tax: A tax on the value of owned real estate and property, based on the appraised value. It’s typically paid either on a quarterly basis to the local authority, or through an escrow account as part of a monthly mortgage payment.
  • Excise tax: A tax typically paid at the time of sale on a variety of goods and services such as alcohol, tobacco, gasoline, and gambling. Sometimes these taxes are referred to in the context of “double taxation” because sales tax may also be imposed in addition to the excise tax.

The good news is that you can minimize or even avoid certain state and local taxes. Investing in specific types of funds, or in specific types of accounts, can help reduce what you owe. You can even reduce or avoid certain taxes by living in a state with tax laws that help you keep more in your wallet.

Treasury bond interest is not taxable at the state level.

Most states and localities with income tax requirements look at your federal tax return as a starting point, and then they make adjustments. This means that your taxable income at the federal level might be higher or lower than your taxable income at the state level. One reason your state income might be lower is due to U.S. government interest, because it’s taxed at the federal level but not at the state level.

Most of our portfolios here at Betterment contain at least some income from U.S. Treasury bonds, unless your allocation is set to 100% stocks.

Municipal bond interest provides double, or even triple, tax benefits.

Municipal bonds are another component of tax-smart investing, particularly because the interest they earn is generally not taxed at the federal level. The highest income tax rate at the federal level is 37% plus an additional 3.8% tax on investment income. Reducing what’s taxed helps you keep more in your wallet. Not having to pay any % of income tax on your municipal bond interest can help you keep more of what you earn.

But, why settle for one tax exclusion when you can get two…or even three? States generally don’t tax interest on municipal bonds issued within their borders (but they do tax interest from out-of-state municipal bonds), so residents who buy them can typically collect interest without having to pay state taxes.

Residents of cities that assess their own income tax, like New York City, could exclude income from municipal bonds issued within their state on their city tax forms, too, resulting in a tax-break trifecta of federal, state, and city tax breaks.

New York and California Residents

State municipal bonds are most advantageous for those in high-income tax brackets.

Our standard portfolio for taxable accounts utilizes MUB, a bond ETF providing exposure to municipal bonds from all states. We offer ETFs that invest solely in either New York or California municipal bonds, for New York and California residents with a minimum balance, or an intent to fund, of at least $100,000. If you want to switch out MUB in your portfolio to CMF or NYF, please email us. We generally recommend making this switch before you fund your account.

The state you live in affects how much you’ll owe in taxes.

State and local income taxes can significantly reduce the amount of cash you have left after paying taxes—and this varies based on the state you live in.

California, New York State, and New York City typically have the highest personal income tax rates in the U.S. California’s highest income tax rate is 13.3% and New York City residents pay up to 12.696%. Note that only New York City residents pay New York City income tax. New Yorkers who live outside of New York City do not pay any New York City income tax, instead, they’ll pay the state up to 8.82%.

These rates apply to all types of income unless there is a special exclusion or exemption. The state and local income tax burden has recently increased due to tax reform. The federal tax deduction for all state and local taxes paid by a taxpayer is now limited to $10,000 per year.

Distributions From Retirement Accounts

Certain states provide a full or partial exemption from state and local taxes for distributions from your retirement accounts. Each state has its own rules and limitations. There are a few states with income tax rules that are generous to retirees.

  • Illinois has a blanket retirement income exemption for withdrawals from 401(k)s, IRAs, pensions, and even for Social Security payments.
  • Pennsylvania has similar income tax exemptions to Illinois but may impose taxes for early retirees.
  • New York allows for each spouse to exclude up to $20,000 from 401(k)s, IRAs, and corporate pension income per year, and also excludes Social Security payments from income tax.
  • California taxes all retirement income at the same rate as the federal government with the exception of Social Security payments, which are automatically exempt.

If you move states in retirement, your former state of residence cannot tax your retirement income. Only the new state can, which means you can avoid taxes by moving to a state that generally doesn’t have any taxes on retirement income, like Florida or Pennsylvania.

Get personalized guidance from Betterment.

Please note that Betterment is not a tax advisor—please consult a tax professional for further guidance.

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