Most U.S. taxpayers are used to double-dread at tax time. First off, most of them end up paying either an accountant or TurboTax to settle their taxes. Second, they have to pay the federal income tax that applies to everyone no matter the state they live in. Third, most states also impose their own income tax on residents. Generally speaking, the tax rate applied by states is smaller than the rates imposed by the federal government.
Some states, however, impose no extra tax burden. In fact, there are seven states in the U.S. that have no state income tax at all – Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Before discussing the benefits of states with no income tax, it’s helpful to understand a little more about how income taxes work on a federal and state level.
The Differences Between Federal and State Income Tax
The first difference between federal and state income taxes is that federal income tax is imposed by the Federal Government and applies to everyone living and working in the U.S. The money collected is used to pay the bills and obligations of the Federal Government, including funding agencies, building interstate highways, and paying federal employee salaries. On the other hand, state income tax, when collected, funds the government of the individual state. Much like its federal counterpart, state tax will typically be used to pay for state agencies, state highways, and state employee salaries, among other things. It is the decision of each state whether or not to charge its residents state income tax.
The Internal Revenue Service (IRS) is in charge of collecting income tax for the federal government. When determining the amount that an individual owes, the IRS applies what is known as marginal tax brackets. This means that income up to a certain amount is subject to a specific percentage, such as 10 percent, and the tax rate increases from there. In 2017, federal tax rates begin at 10 percent for income up to $9,325 (for single people) and income from $9,326 – $37,950 at 15 percent. The rates go up from there, all the way to 39.6 percent for income above $418,401. The tricky thing to remember about federal tax brackets is that only part of your income will fall within each bracket – you are not simply taxed at the highest bracket on all of your income.
State income tax is collected by the individual state’s department of revenue. States also typically use brackets, but they tend to be much lower than the brackets for the Federal Government. For example, California tax brackets for 2017 start at just 1 percent and max out at 13.3 percent. Other states have done away with brackets and simply impose a flat tax rate on all levels of income. Colorado, for instance, imposes a flat rate of just 4.63 percent.
States with No Income Tax
How do seven states manage to charge no income tax while the other forty-three require it? After all, those states still need to figure out a way to pay their employees, build and maintain roadways, and pay for other state budget expenses. The answer is, these seven states recoup money in other ways. Here is a breakdown of some of the ways that states with no income tax manage to stay afloat.
Washington – The most northwesterly state in the continental United States has no income tax, but it does have some of the highest sales tax. If you live in Washington, your combined state and average local sales tax will be around 8.9 percent, which is fifth-highest in the U.S. In fact, Seattle’s population pays a combined sales tax of 9.6 percent – the highest of any city in any state. Although Washington used to rely more heavily upon state revenue from property taxes, the state legislature passed restrictions on property tax increases in 2000, which has contributed to Washington’s high reliance on sales tax to fund the state’s expenditures.
Texas – The Lone Star State imposes a state sales tax of 6.25 percent on retail sales, leases and rentals of goods, and taxable services. In addition, local taxes (imposed by counties, cities, and districts) impose up to an additional 2 percent, for a combined tax rate of up to 8.25 percent. The high sales tax rate is one of the ways that Texas generates revenue to make up for the fact that it imposes no income tax. Twice a year –in Spring and Fall – Texas has tax-free weekends on specific goods. In August, a tax-free weekend promotes purchase of school supplies such as backpacks, clothing, pencils, and footwear. Residents who take advantage of these can save around $8 for every $100 they spend – probably a much-appreciated break for residents who pay some of the highest sales taxes in the U.S.
Alaska – Residents of Alaska are the only ones in the U.S. to be exempt from both personal income tax and state sales tax. Their state is in a rather unique economic situation, having large amounts of petroleum reserves on which it relies to fund state expenses. If you don’t mind living in cold weather much of the year and like wide, open spaces, Alaska will gladly charge you almost no taxes to live there. However, the exemption from sales tax comes with a small caveat – some of its cities and smaller jurisdictions do collect nominal sales tax within their borders.
South Dakota – Most Midwest states’ largest revenue comes from income tax, however South Dakota makes our list as the only state in that region which charges no income tax to its residents. Like the other states on our list, its largest form of revenue comes from sales tax. However, it also enjoys a reputation as a low-tax state in general, with its state sales tax rate falling into the bottom half of all states nation-wide.
Florida – The Sunshine State imposes no income tax because its state constitution actually forbids the imposition of an income tax. To make up for lost revenue, Florida charges 6 percent sales tax and smaller municipalities impose their own discretionary sales tax, up to an additional 2 percent. This tax applies to sales, leases, and rentals, as well as taxable services. The majority of Florida’s state revenue comes from sales tax and, like other states on our list, their sales tax is among the highest in the nation.
Nevada – For those who love to gamble and hate to pay income taxes on their winnings, the state of Nevada is a great place to live. Not only does Nevada not impose an income tax on individuals, it’s one of few states that don’t even charge corporations income tax. Nevada residents do pay a high sales tax, however, and one of the highest gasoline taxes in the nation ($0.33 per gallon).
Wyoming – The residents of the least-populated state in the U.S. also enjoy more money in their pocket at tax time. Wyoming rounds out our list of states with no income tax. What’s more impressive, Wyoming is the state on our list with the lowest state sales tax, coming in at a mere 4 percent with up to an additional 2 percent imposed locally, depending upon where the purchase is made.
Retiring in a State with No Income Tax
It can put more money into your pocket to retire in a state with no income tax. However, it’s risky to simply assume that moving to a particular state will save you money overall without doing your research to compare other costs between states. As shown on our list, higher sales tax often compensates a state for lack of income tax. In addition, states with no income tax generally tend to be higher-cost states to live in, due to higher property taxes, sales taxes, and cost of living.
What’s more, for retirees whose primary source of income is social security, many states not on our list specifically do not tax social security benefits, even though they may tax other forms of income. It’s important to consider the overall tax nature of a particular state, including taxes on such things as gasoline and property, and particularly to evaluate whether cost of living is higher or lower than normal. Retiring in a state with no income tax does not necessarily save a retiree money if their housing cost doubles and higher sales tax results in less purchasing power.
That said, there are some states, such as Wyoming, where no income tax, low cost of living, and low sales and property taxes all converge. It’s hard to make a case against retiring in a state such as that—unless it’s lack of a beach! No matter where you choose to retire, take the time to evaluate what is most important to you and do your research into tax breaks specifically for retirees. For instance, many states with high property tax offer tax exemptions for senior citizens age 65 and older. Programs such as these can often offset the higher cost of living typically found in states with no income tax.