The tax system can be intimidating for businesses and individuals and requires careful navigation through its many complexities. Understanding the distinctions between federal and state taxes is fundamental to ensuring accurate filing and maximizing tax efficiency. This blog explores federal and state income taxes’ key characteristics, functionalities, calculation methods, and critical differences.
Table of Contents
What is Federal Income Tax?
The federal income tax is a mandatory payment imposed by the United States government on the income earned by individuals, businesses, trusts, and estates subject to taxation. It is crucial in funding various public programs and services and is the federal government’s primary revenue source.
How Does Federal Tax Work?
Taxable Income:
The first step in calculating federal income tax involves determining your taxable income. This is reached by subtracting allowable deductions and exemptions from your gross income (total income earned). Standard deductions include business expenses, charitable contributions, and mortgage interest.
Tax Brackets:
The federal income tax system utilizes a progressive tax structure, meaning tax rates increase as taxable income rises. There are currently seven federal tax brackets, each with a corresponding tax rate. As your taxable income increases, a higher marginal tax rate is applied to a portion of your income within that bracket.
Tax Filing:
Taxpayers and companies must file their tax returns annually with the Internal Revenue Service (IRS). The filing deadlines and forms required depend on the individual’s or business’s tax situation.
Here’s a simplified example of how federal income tax might work:
- John earns a salary of $100,000 per year.
- He claims standard deductions of $12,550 for his filing status.
- John’s taxable income becomes $100,000 – $12,550 = $87,450.
- Assuming John falls within the 24% federal tax bracket, his federal income tax liability would be calculated as follows:
Tax Liability = Taxable Income x Tax Rate
- Tax Liability = $87,450 x 24% = $20,988
Important Note: This is a simplified example, and additional factors like tax credits and alternative minimum tax (AMT) might influence the final tax liability.
What is State Income Tax?
Individual states collect state income tax from their residents for their income within their jurisdiction. It is a tax levied on earned income, including wages, salaries, tips, and other types of compensation.
Not all states have an income tax, but for those that do, it is a significant revenue source for state governments. The amount of income tax that an individual pays depends on their income level, tax bracket, and other factors such as deductions and exemptions.
The revenue generated through state income tax funds various programs and services such as education, healthcare, infrastructure, and public safety. Some states also use the revenue to fund programs that provide tax credits and incentives to businesses to encourage economic growth.
How Does State Tax Work?
Similarities to Federal Tax:
State income tax shares some features with federal income tax. Like the federal system, most states employ a progressive tax structure with varying tax brackets and deductions. Individuals and businesses must file state income tax returns with their respective state tax agencies.
Key Differences:
However, several key differences exist between federal and state taxes:
- Tax Rates: State tax rates generally fall below federal tax rates, with some states having no income tax.
- Taxable Income: State definitions of taxable income differ slightly from federal guidelines. Some states may allow additional deductions not recognized on the federal return.
- Filing Requirements: Filing requirements for state income tax can vary depending on the state and your specific tax situation. Some states may require filing even if you have no tax liability.
Here’s a table summarizing the key differences between federal and state income tax:
| Feature | Federal Income Tax | State Income Tax |
| Imposing Authority | Federal Government | Individual State Governments |
| Purpose | Funds federal government programs | Funds state government programs |
| Tax Brackets | Yes, progressive rates | May or may not have brackets, and rates may vary |
| Deductions | Standard and itemized deductions | May differ from federal deductions |
| Filling Requirments | Annual filing with the IRS | Varies by state and may require filing even with no tax liability |
Federal Tax vs State Tax – Example
Let’s revisit the example of John, who earns a salary of $100,000 per year:
- John lives in a state with a flat 5% income tax rate.
- Assuming his federal tax liability is calculated as $20,988 (as shown in the previous example).
- John’s state income tax liability would be:
Tax Liability = Taxable Income x Tax Rate
- Tax Liability = $87,450 x 5% = $4,372.50
Total Tax Liability: John’s total tax liability would be the sum of his federal and state tax liabilities, which is $20,988 (federal) + $4,372.50 (state) = $
Difference Between Federal Tax vs State Tax
Building upon the previous examples, here’s a more detailed breakdown of the key differences between federal and state income taxes:
- Tax Base: While federal and state taxes might use taxable income as the starting point, how they arrive at that figure can differ. Federal tax law allows for various deductions and exemptions, like student loan interest or contributions to retirement accounts. Some states may conform entirely to the federal definition of taxable income, while others might have additional deductions or adjustments specific to their state.
- Tax Rates: The structure of the federal income tax system is progressive and comprises seven tax brackets that range between 10% to 37% (applicable in 2024). State income tax rates and structures vary considerably. Some states have progressive tax brackets similar to the federal system, while others might have flat tax rates (a single rate applied to all taxable income) or no income tax at all.
- Tax Credits: Both federal and state governments offer various tax credits that can reduce your tax liability. These credits can be for specific activities like education expenses, childcare, or energy-efficient home improvements.
Here’s a table summarizing these key differences:
| Feature | Federal Income Tax | State Income Tax |
| Tax Base | Defined by federal tax law, may include deductions and exemptions | It may differ from the federal definition. Additional state-specific deductions are possible |
| Tax Rates | Progressive structure with seven brackets (10% – 37%) | Varies by state, progressive brackets, flat rates, or no income tax |
| Tax Credits | Available for various activities | Available for multiple activities, may differ from federal credits |
Additional Considerations:
- Sales Tax: Besides income taxes, most states and some localities levy sales tax on selling particular goods and services. Sales tax rates vary significantly by state and can even be compounded by local jurisdictions. Understanding sales tax is crucial for businesses operating in multiple locations.
- Payroll Taxes: Payroll taxes are a separate federal tax category levied on employers and employees. The Social Security and Medicare programs are funded by the taxes collected. The employer and employee share responsibility for these taxes, each typically contributing a specific percentage of wages.
- State and Local Taxes: Many states and localities impose additional taxes beyond income tax. These can include property taxes, gasoline taxes, and various fees. Staying informed about these additional levies is essential for businesses and individuals alike.
Conclusion
Knowing the differences between federal and state taxes is crucial for efficient tax planning and adherence to regulations. This blog has provided a foundational framework for these differences. Businesses and individuals are encouraged to consult with tax professionals for personalized guidance based on their circumstances and locations.
Profitjets provides a range of tax services to assist businesses in dealing with the intricacies of federal, state, and local tax regulations. These comprehensive services aim to provide businesses with all the necessary guidance to navigate tax regulations easily. Contact us today to learn more about how we can streamline your tax processes and ensure compliance.
