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Americans who live in one state and earn money in another must generally pay non-resident income tax to the state where they earn their money, but there are several variations on this theme. For example, some states don’t tax income. In other cases, some neighboring states have implemented arrangements that help their residents avoid filing multiple state income tax returns.
State Income Tax
Only seven American states do not impose a tax on income. The other 43 generally tax all income earned by their residents, as well as income earned within their borders by non-residents. There is no issue for residents of a non-income tax state who work in a state that taxes income: they must pay non-resident taxes to the state where they earned their income. Likewise, residents of an income tax state that work in a non-tax state must pay resident income taxes to their home state on the income earned out-of-state. State income taxes are withheld from salaries and wages, and taxpayers must file an annual income tax return to settle up.
Non-Resident Income Taxes
States that tax income also tax non-residents for their in-state earnings. In addition to earned income, other reasons a non-resident might be required to file a non-resident return and pay taxes are earnings from a partnership or "S" Corporation, or gambling winnings. In addition, if income taxes were withheld in error, the only way to recover them is to file the state’s non-resident income tax return and claim the refund. The justification for taxing non-residents’ income is that commuters put a significant strain on state services and infrastructure. In many cases, the rates charged to non-residents are lower than to residents, considering that commuters generally use less of these services than do residents.
Many income tax states have reciprocal arrangements with neighboring income tax states that provide that residents who live in one and work in the other must pay income taxes only to their home states. For instance, New Jersey and Pennsylvania have a reciprocal arrangement that allows their residents to work in the other state and only pay income taxes to their home state. These residents must file a special form with their employer to ensure proper withholding of state income tax for the appropriate jurisdiction.
Paying Income Taxes to Multiple Jurisdictions
There are several sets of neighboring income tax states that do not share a reciprocal income tax agreement. Their residents who work in neighboring states must file resident tax returns in their home states and non-resident returns in the states where they work. In general, the jurisdiction where money is earned has first claim on the taxes, and so the non-resident return should be completed first. State resident income tax returns generally allow taxpayers to take credit for taxes paid to other jurisdictions, although there may be limitations to such credits.
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