Cashing in on state tax breaks; don't overlook ways your state's rules differ from those imposed by the IRS

Kiplinger's Personal Finance Magazine, March, 1998

It's no wonder that many people treat their state tax return as a mere nuisance to be completed quickly after slaving over the federal form. After all, many of the numbers come straight from the Form 1040, so filling out the state forms doesn't take as much original thought. And the top tax rate, rarely more than 10%, is far less threatening than the 28% -- or even 39.6% -- rate that cuts into earnings on federal forms.

But you treat your state return as an afterthought at your peril. State forms are rife with quirky departures from the federal rules -- and most of the differences represent a chance to save money.

On the downside, however, there are ways that states' nonconformity works against their residents' checkbooks. For example, California does not have a special rate for capital gains; its residents still pay standard income-tax rates on their investment profits, despite the new 10% and 20% caps for long-term gains at the federal level. Massachusetts is even more stern: It clips short-term capital gains and dividends at 12% -- more than twice the state's flat, 5.95% income-tax rate. And Bill Clinton's Arkansas is loath to allow tax-free gain on home sales; residents who take that exemption on their federal Form 2119 must file a newly minted state form to report home-sale profit for state-tax purposes.

To encourage you to spend some quality time with your state forms, consider the following ways that states' tax laws differ from the federal tax code -- and be sure to check your state instructions carefully for similar twists and turns: 1. Married people who file jointly on federal returns may file separately in Arkansas, Delaware, Iowa, Kentucky, Mississippi, Missouri, Montana, Virginia and Washington, D.C. That generally cuts a two-earner couple's tax by increasing the proportion of income that is taxed in lower brackets. South Carolina and Wisconsin ease the marriage-tax penalty by offering joint filers a credit worth up to $210 and $300, respectively. 2. Some interest that's taxed by the IRS is tax-free at the state level. If you invested in Treasury securities (or your mutual funds did), you probably have less interest income to report on your state return than on your federal. Mutual funds, including stock funds (which often invest short-term cash holdings in Treasuries) and money-market funds, annually report the percentage of their earnings attributable to Treasuries; if you can't find the statement that includes this money-saving information, call the fund's "800" number to get it. Investors in Vanguard Asset Allocation fund, for example, will find that 61% of its 1997 earnings came from the 30% of its assets invested in Treasuries and therefore avoid taxation in most states.

Residents of California, Connecticut and New York are at a disadvantage because their states require that at least 50% of a mutual fund's assets be invested in Treasuries before the tax-free-interest break can be passed on to investors. (Help may be on the way, though. A New Jersey requirement that funds be at least 80% invested in Treasury securities before any of the interest could be state-tax-free was recently struck down in court.) 3. Some states have their own special breaks for capital gains. In Wisconsin, 60% of profits from assets held more than one year are tax-free. (The state didn't extend the long-term holding period to 18 months as the feds did.) In South Carolina, investors owe no tax on 44% of the gain from assets held more than two years. Starting in 2002, assets sold after at least six years will incur no tax in Massachusetts.

John Czajkowski, a financial planner in Greenfield, Wis., will cash in when he files his `97 state forms. He and his wife, Deb, realized $15,000 in capital gains last year when they sold stock and mutual fund shares to buy land for a new office building. They'll report $9,000 less in capital gains on their Wisconsin forms than on their federal return. And that will save them about $500.

"I don't make investment decisions solely for tax reasons," explained Czajkowski, 47. "But it's sweet to take advantage of the tax benefit." 4. Illinois recently ended its reciprocal tax agreement with Indiana, so people who live in one state but work in the other must now pay income tax to the state in which they work, and not to their home state. (The rates are close, so there's not much advantage either way.)

If you have just started crossing the state line for work, check with your employer and your home state to learn more about your tax liability. Pennsylvanians who work in neighboring Maryland, for example, owe Maryland no tax on their earnings and have Pennsylvania income tax withheld from their paychecks. Pennsylvania residents who work in Delaware, however, owe tax in both states, but they get a Pennsylvania credit to offset the amount paid to Delaware. 5. Be sure you capitalize on any special incentives for charitable contributions. Donations to a state college in Indiana or Montana, for example, earn you a tax credit, in addition to the itemized deduction you carry over from your federal return. A donation to Valparaiso University, for example, would earn a married couple in Indiana a credit of either half their gift or $200, whichever is less. Montana's credit is a straight 10% of the contribution, up to $500. 6. Self-employed Iowans and Ohioans can write off 100% of their health insurance premiums, versus just 40% on their 1997 federal forms. 7. The federal government taxes unemployment benefits and state-lottery winnings, but if you receive either in California, you can subtract the amount from your income for state-tax purposes. 8. In Colorado, Iowa, New York and Ohio, among others, retirement is a bit less taxing, says Willy Weinstein, senior tax-research specialist at H&R Block. That's because some or all of social security, pension and IRA payouts are sheltered from the tax man. If you prepare your elderly parents' returns, you should beware of simply carrying over their income as figured on the federal 1040. Iowa, for example, taxes no more than half of a retiree's social security benefits, while the IRS can take aim at as much as 85%. 9. Indiana residents who donate a computer to a state-run educational program may qualify for an income-tax credit of up to $100. There's a special Form PC-10 for donors. 10. Make sure you get all the breaks you have coming from a state prepaid college-tuition plan. The savings might be more generous than you realize. Contributions to New York's plan, for example, are tax-deductible going in and tax-free coming out. (The earnings are federal-tax-deferred, too.)