With federal tax reform setting a limit on the state and local tax deduction, residents in many highly taxed states, such as New York, New Jersey, Illinois, California, and Massachusetts, will be affected more than other taxpayers.
Under the Tax Cuts and Jobs Act (TCJA), the state and local tax deduction (SALT) is limited to $10,000 annually. Previously, this deduction on the federal tax return lowered the effective tax rate at the state level for individual taxpayers. The impact is obvious for high-tax states. For example, the average SALT deduction for New York taxpayers on federal returns is over $20,000.
Taxpayers in these states need to consider the loss or limitation of deductions on their federal income tax bill, which could affect their state income tax, and could mean a higher tax bill in the future. Taxpayers who have residence in different states may want to consider establishing a domicile for tax purposes.
Additional concerns for state taxes
There are other considerations beyond the limitation on the SALT deduction. More than 40 states have a personal income tax, and many states tie their state system to at least some components of the federal tax system (referred to as conformity). Significant changes in the federal system can have downstream effects. Many states are currently navigating the complexities of their tax system as it relates to conformity. For these taxpayers, the jury is still out as to whether they will benefit or have to pay more next year.
The Tax Policy Center recently published a report providing significant detail on the state tax issues.
How does the state link to the federal tax system when considering income?
Most states tied to the federal system link to adjusted gross income (AGI). The TCJA made only minor changes to the calculation for AGI. These states may be less affected by the TCJA.
There are a few states that link to taxable income instead, which changes dramatically under the TCJA (limitations in deductions, new 20% deduction for pass-through income, etc.) These states will be the most affected by federal tax reform.
Does the state link to certain federal tax provisions, specifically the standard deduction and personal exemption?
Some states tie their taxes to one or both of these provisions. If so, the TCJA may have a significant impact.
The standard deduction is nearly doubled, and the personal exemption is eliminated. Does this create winners and losers in certain state tax systems? The doubling of the standard deduction likely helps retirees, while the loss of the personal exemptions may negatively impact larger households. Additionally, some states are tied to the federal child tax credit (CTC), which is expanded and will likely benefit families with children.
Under the TCJA, K–12 tuition is now a qualified expense for 529 college savings plans. How does this affect 529 tax advantages at the state level?
Many states offer state tax incentives to establish and fund a 529 plan offered by that state. In fact, more than 30 states offer tax benefits for 529 contributions.
States seek clarity
State budget offices are analyzing the impact of the federal tax law and changes in deductions and exemptions. In some cases, state legislators are considering introducing legislation to adjust state income tax systems. Taxpayers should consult with a tax professional to understand how the TCJA may positively or negatively impact their state income tax return, and how this could influence their overall financial plan.