Do You Get Taxed Twice if You Work in Another State?
When you work in a different state, both states can tax your income. Understand the principles that resolve this conflict and prevent double taxation.
Working in one state while living in another introduces complexity to an individual’s tax situation. A concern is the possibility of being taxed on the same earnings by two different states. While two states may have a claim to tax your income, the system has provisions designed to prevent the same dollar from being fully taxed twice.
Understanding Residency and Source Income Rules
State tax obligations are determined by two concepts: your state of residence and the source of your income. Your state of residence, your domicile, is the state where you have your permanent home. This state reserves the right to tax all of your income, no matter where you earn it.
The second concept is “source income,” which refers to money earned in a specific location. A state where you are not a resident, but where you physically perform work, has the right to tax the income you generate within its borders. This creates a potential overlap where your home state can tax your worldwide income, and your work state can tax the income earned there.
State Reciprocity Agreements
A straightforward solution to avoid being taxed by two states is a reciprocity agreement. This is a formal pact between states that allows a resident of one state to work in the other and only pay income tax to their state of residence. These agreements simplify tax compliance for commuters by eliminating the need to file a nonresident return in the work state.
To take advantage of a reciprocity agreement, you must file a specific withholding exemption certificate with your employer. The form’s purpose is to certify that you are a resident of a reciprocal state and therefore exempt from that state’s income tax withholding. Once processed, your employer will stop withholding taxes for your work state. These agreements are not universal and only exist between certain states, often those that share a border.
Credit for Taxes Paid to Another State
When no reciprocity agreement exists, the main method for avoiding double taxation is the credit for taxes paid to another state. This mechanism ensures you do not pay tax twice on the same income, as your home state provides this credit on its resident tax return. The process begins by preparing a nonresident tax return for the state where you work to determine your tax liability there.
You then complete the resident return for your home state, which taxes your entire income but allows a credit for the taxes paid to the other state. A limitation on this credit is that it is capped at the lesser of the tax you paid to the nonresident state or the tax your resident state would have imposed on that same income. For example, if you paid $2,000 in taxes to a nonresident state and your home state’s tax on that income would have been $1,500, your credit would be limited to $1,500.
The State Tax Filing Process
The sequence for filing your tax returns is an important part of managing a multistate tax situation. When claiming a credit for taxes paid to another state, you must complete the nonresident state tax return first. The tax liability calculated on the nonresident return is a necessary figure for completing your resident state return.
For individuals covered by a reciprocity agreement, the process is much simpler. After providing your employer with the correct exemption form, you will only need to file a single tax return in your state of residence.