Are State Taxes Calculated After Federal?

The relationship between federal and state income taxes can be confusing. Whether state taxes are calculated after federal taxes depends on the laws of the state where you file. For most people, completing the federal tax return is the first step before starting a state return, as the two are closely linked.

The Role of Federal Adjusted Gross Income

The primary reason federal and state tax filings are interconnected is the Adjusted Gross Income (AGI) from your federal return. AGI is your gross income from all sources, minus certain “above-the-line” deductions like contributions to a traditional IRA or student loan interest. This AGI figure serves as the starting point for income tax calculations in most states.

The majority of states with an income tax use a taxpayer’s federal AGI as the foundation for the state tax return. This approach simplifies the process for taxpayers and state agencies by creating a standardized baseline. This direct link is why taxpayers in these states must complete their federal return first; without a finalized federal AGI, the state return cannot begin.

This reliance on federal AGI means that changes to federal tax law concerning deductions can directly impact state tax calculations. States using federal AGI automatically conform to these federal definitions unless they pass specific legislation to “decouple” from a rule. This conformity creates a streamlined system where states use the federal income base as their starting point.

State-Specific Adjustments to Income

Once federal AGI is carried over to a state return, the calculation process is not complete. States use this figure as a baseline but then require various adjustments—additions and subtractions—to arrive at state taxable income. These modifications are necessary because state tax laws often differ from federal laws regarding what income is taxable.

Additions

Additions are items that were not taxed on your federal return but are taxed by your state. A common example is interest earned from municipal bonds issued by another state. While interest from municipal bonds is exempt from federal income tax, a state will tax the interest earned from bonds issued by any state other than itself. You must add that interest income back on your state tax return.

Subtractions

Subtractions are items of income included in your federal AGI but not taxed by your state. A prominent example is interest income from U.S. Treasury bonds. This income is subject to federal income tax but is exempt from taxation at the state and local levels. Taxpayers must subtract this income on their state return.

Another frequent subtraction is Social Security benefits. While a portion of these benefits can be taxable at the federal level, many states fully or partially exempt them from their own income tax.

The Federal Income Tax Deduction

A small number of states take the connection to the federal system a step further by allowing a deduction for federal income taxes paid. This is a less common practice than using federal AGI as a starting point. In these states, taxpayers can subtract the amount of federal income tax they paid from their state income, which reduces their state taxable income. This is a literal calculation of state tax after federal tax liability is determined.

Currently, only a few states offer this deduction. Alabama, for instance, allows for a full deduction of federal income taxes paid. Missouri and Oregon also permit the deduction, but they impose limits, such as capping the deductible amount or phasing it out for higher-income earners.

This should be distinguished from the state and local tax (SALT) deduction available on the federal return. The federal SALT deduction allows taxpayers who itemize to deduct state and local taxes they have paid, up to a limit of $10,000 per household. The federal income tax deduction discussed here is a state-level deduction, allowing federal taxes to reduce state income.

States with Unique Calculation Methods

While using federal AGI is the most common method, it is not universal. A handful of states have established their own distinct systems for calculating taxable income, independent of federal AGI. These “build-up” states require taxpayers to calculate their state income by adding together various sources of income as defined by that specific state’s law. This results in a more separated filing process where the state return is less of a direct continuation of the federal return.

States with their own income calculation rules include:

• Alabama
• Arkansas
• Mississippi
• New Jersey
• Pennsylvania

A number of states do not levy a broad-based personal income tax at all. For residents of these states, the question of how state and federal taxes interact is moot, as they have no state income tax liability to calculate. States that do not tax wage and salary income include:

• Alaska
• Florida
• Nevada
• New Hampshire
• South Dakota
• Tennessee
• Texas
• Washington
• Wyoming