Key Differences Between Federal and State Tax Treatment of Income

Overview

Federal and state tax systems both tax income, but they do so under different rules, rates, and policy goals. The Internal Revenue Service (IRS) administers federal income tax on all U.S. taxpayers; most states levy their own individual and corporate income taxes with varying degrees of alignment to federal law. These differences affect tax brackets, what counts as taxable income, available deductions and credits, and the practical tax owed after accounting for both levels of tax.

This article explains the common areas where federal and state treatments diverge, practical examples, and actionable planning steps you can use to reduce surprises from withholding, relocation, or multistate work. Sources include the IRS, the National Conference of State Legislatures (NCSL), and the Tax Foundation (references cited inline). This is educational material and not tailored tax advice—consult a tax professional for decisions that affect your personal situation.

The big-picture differences

• Who sets the rules: Congress and the IRS set federal tax law; state legislatures set state tax law. States sometimes “conform” to the federal Internal Revenue Code (IRC) for simplicity, but they may adopt, delay, or reject federal changes (often called conformity).
• Rate structure: Federal rates are progressive with top rates currently ranging from 10% to 37% for ordinary income (as of 2025) (IRS). State rates vary widely: some states have flat rates, others use progressive brackets, and nine states impose no individual income tax at all (NCSL, 2025).
• Tax base differences: States often start with federal adjusted gross income (AGI) or taxable income as a baseline, then add or subtract items (add-backs or subtractions) that create differences. Common state-specific adjustments include treatment of retirement income, state tax refunds, and certain federal credits.

Sources: IRS.gov (federal tax rules and brackets), NCSL (state tax availability and types), Tax Foundation (comparative state rates).

Key areas where federal and state treatment commonly differ

1. Taxable income definitions and conformity

• Conformity: Many states adopt federal definitions by reference, but they can conform to the IRC as of a specific date or selectively adopt provisions. That means a federal law change (for example, a temporary pandemic-related rule) might not automatically change state tax rules. Check your state’s conformity date and statutes.
• Add-backs and subtractions: States will add back certain federal deductions or subtract income categories that the state excludes (for example, some states exclude all or a portion of public pension income).

1. Rates and brackets

• Federal: Progressive tax brackets with multiple marginal rates (currently 10% to 37% for ordinary income). These brackets and thresholds are adjusted annually for inflation by the IRS.
• State: Rates range from zero (no income tax states like Florida or Texas) to very high top marginal rates in a few states (California’s top marginal rate has been as high as 13.3% for some income brackets). States differ by how they tax capital gains, qualified dividends, and whether they provide special lower rates.

1. Itemized deductions, credits, and the SALT cap

• Federal SALT limit: The federal deduction for state and local taxes (SALT) remains capped at $10,000 for tax years after the Tax Cuts and Jobs Act (TCJA) through at least 2025 unless Congress changes the law; this cap limits the federal deductibility of state income or property taxes for taxpayers who itemize (IRS).
• State differences: States may not follow the federal standard/itemized deduction rules; many offer different credits and exemptions not recognized federally (for example, state child credits or earned income tax credits with different phase-ins).

1. Retirement income and Social Security

• Federal: Social Security benefits may be taxable federally depending on combined income; traditional 401(k)/IRA withdrawals are taxed as ordinary income.
• State: Some states exempt Social Security benefits entirely; others tax retirement plan distributions only partially or not at all. This can materially change after-tax retirement income for residents of different states.

1. Capital gains and special income types

• Federal: Long-term capital gains and qualified dividends are taxed at preferential rates up to 0%, 15%, or 20% depending on taxable income, with surtaxes for some high earners.
• State: Many states tax capital gains as ordinary income; a few provide reduced rates or carve-outs for capital gains.

1. Business and corporate treatment

• Federal vs. state: Corporations face federal corporate income tax plus varying state corporate income/franchise taxes. Some states use receipts-based apportionment or alternative tax bases; others provide incentives for particular industries. The combined rate and apportionment rules determine the effective state tax on corporate profits.

1. Nexus and remote work

• Remote work and nexus rules can create state tax obligations for both individuals and employers. Working remotely for an employer in another state or having clients across states can trigger withholding and filing requirements in multiple states. See our guide on multistate nexus for remote work and state residency strategies for mobile workers for practical steps (see internal links below).

Practical examples (illustrative)

• Example 1 — Moving to a no-income-tax state: A high-earner living in California may pay federal tax plus California’s top marginal rate; relocating to Florida eliminates state income tax but not federal tax. The move’s net benefit depends on moving costs, property taxes, local sales taxes, and differences in deductions and credits. Always model both federal and state impacts before moving.

• Example 2 — Retirement choices: A retiree with significant Social Security and pension income may be better off in a state that excludes Social Security from taxable income. Even a modest difference in state pension taxation can alter annual cash flow in retirement.

Notes on the illustrative examples: numbers will vary by individual circumstances. Use tax modeling software or a professional before making decisions.

How to evaluate your situation — a short checklist

1. Identify your state(s) of residency and any states where you earned income during the year.
2. Check whether your state conforms to the federal IRC as of a specific date; review state add-backs and subtractions.
3. Estimate combined federal and state marginal tax rates at different income levels to see the real bite of taxation.
4. Model specific events: moving, retirement, sale of investments, or starting a business to see state-level effects.
5. If you work remotely or across states, confirm nexus and withholding obligations for both you and your employer.

Useful internal reading: see our guides on State Residency Tests (State Residency Tests: How to Determine Where You Owe State Taxes) and Multistate Nexus (Multistate Nexus: When Remote Work Creates State Tax Obligations) for practical forms and evidence you can gather.

(Internal links: State Residency Tests: How to Determine Where You Owe State Taxes — https://finhelp.io/glossary/state-residency-tests-how-to-determine-where-you-owe-state-taxes/; Federal vs State Tax Conformity: Common Differences and Planning Tips — https://finhelp.io/glossary/federal-vs-state-tax-conformity-common-differences-and-planning-tips/; State Tax Planning for Mobile Workers and Remote Employees — https://finhelp.io/glossary/state-tax-planning-for-mobile-workers-and-remote-employees/.)

Actionable planning strategies

• Model before you move. Run a multi-year tax projection that includes state tax rules, property taxes, and any planned withdrawals from retirement accounts.
• Time income events when possible. If you can shift capital gains or large IRA/401(k) distributions into years with lower expected combined tax rates, you may save materially.
• Use tax-advantaged accounts strategically. Traditional pre-tax retirement contributions reduce federal and, in many states, state taxable income. Roth conversions require state-level consideration—converting in a state with low or no income tax can reduce conversion costs.
• Watch residency rules and maintain evidence. If you plan to change domicile, document the date you established residency and the actions you took (voter registration, driver’s license, primary home, and time spent in each state).
• Leverage state credits. Some states offer targeted credits for education, childcare, energy improvements, or small-business investments. Those credits can be a dollar-for-dollar reduction in state tax due and sometimes exceed federal incentives.

Common mistakes to avoid

• Assuming federal tax results map directly to state tax outcomes. Many taxpayers underestimate effective combined tax rates because states tax items differently.
• Ignoring multistate filing requirements. Working in multiple states can require multiple returns and create withholding mismatches.
• Forgetting the SALT cap’s federal impact. High state and local taxes may not be fully deductible federally because of the $10,000 SALT limit (IRS).

Resources and citations

• IRS — see the main federal tax resources and current bracket information at IRS.gov (IRS, 2025).
• National Conference of State Legislatures (NCSL) — for an updated list of which states impose individual income taxes and details on state-specific provisions (NCSL, 2025).
• Tax Foundation — for comparative state tax rate analysis and interactive maps (Tax Foundation, 2025).

For further details on related topics, read our posts: “Federal vs State Tax Conformity: Common Differences and Planning Tips” (https://finhelp.io/glossary/federal-vs-state-tax-conformity-common-differences-and-planning-tips/) and “State Residency Tests: How to Determine Where You Owe State Taxes” (https://finhelp.io/glossary/state-residency-tests-how-to-determine-where-you-owe-state-taxes/).

Final thoughts and professional note

In my practice, I’ve seen taxpayers materially change their after-tax income and retirement cash flow simply by understanding state-level differences—particularly retirees and mobile workers. Small differences in tax treatment (for example, whether a state taxes retirement pay or excludes Social Security) can change decisions about when to claim benefits, where to live, or when to realize capital gains.

This article is for educational purposes only and does not constitute tax or legal advice. Rules change and states update their conformity and rates; consult a qualified tax advisor or CPA before making moves that affect your tax residency, business operations, or long-term financial plan.