Federal vs. State Tax: What Is The Difference?

Summary:

The federal government collects federal taxes to fund public services that the government provides on a national level, such as healthcare and defense. State taxes are used to pay for more localized state government programs and state-level infrastructure, among others. Federal taxes are higher than state-level taxes, as states and localities have other methods of collecting revenue through property and payroll taxes.

As annoying as they are, taxes are a necessary evil and fund many of the public services Americans rely on. These include national social programs like Medicare, Social Security, defense, and large infrastructure projects as well as education and localized infrastructure.

While these programs are helpful, are they all funded by federal taxes? Why do some states charge income tax but others don’t? In this article, we’ll take a closer look at federal and state income taxes as well as taxes paid on the local level.

Federal income taxes 101

Anyone who resides in the United States needs to pay federal income taxes. In fact, even American citizens who don’t reside in the U.S. need to pay federal income taxes if their foreign-earned income is higher than the U.S. Foreign Earned Income Exclusion.

Federal income taxes are levied on what the U.S. government refers to as “ordinary income.” Ordinary income is the taxable income you receive from work or business activities. Federal income taxes differ from state income taxes by the public services that they fund.

Below are the current federal income tax rates and brackets for the year 2023:

Federal income taxes use a progressive income tax system. This means that the more money you earn, you must progressively pay higher rates of tax. The Internal Revenue Service dictates that a person earning $500,000 a year will pay a higher marginal rate of tax than someone earning $50,000.

This differs from a flat tax rate, in which everyone pays the same marginal rate of tax, regardless of income. Everyone, however, qualifies for the standard deduction.

Standard deduction

Not everyone is required to pay federal income taxes. People only have to pay federal income taxes if they make more than the standard deduction.

Below are the standard deduction amounts for 2023:

For example, let’s say you make $66,000 per year. Here is what you actually pay tax on, using this federal income tax example.

Income$66,000
Standard deduction$13,850
Taxable income$52,150

Pro Tip

There’s also a standard deduction for state income tax. However, since this differs from state to state, it’s best to do some research to see if you qualify for a standard deduction in your state.

What do federal taxes pay for?

Federal taxes pay for everything on a large national scale that the federal government provides regarding public services. Large healthcare programs (such as Medicare) and major infrastructure projects, such as the Interstate Highway System, are partially paid for through federal taxes.

Federal taxes also pay for everything that government deems to be in the national interest. For instance, the State Department and various intra-governmental organizations — such as the IMF, the World Bank, and the military — are funded by federal income taxes.

Below is a breakdown of how federal taxes are distributed. You can see that nearly 50% of all federal taxes go to Social Security and defense.

Pie chart demonstrating what federal income taxes fund
Source: Center on Budget and Policy Priorities

State income taxes 101

State income taxes are levied on ordinary income that is earned by the resident of a particular state. And while state taxes are often significantly lower than federal income taxes, some states have no state income tax at all.

Furthermore, there are states that use progressive taxation systems similar to the federal tax code and those that use a flat tax system. Below is a breakdown of states and the tax systems they use.

IMPORTANT! While it may seem smart to live in a state with no state income tax, keep in mind that these states make up the money through other means. For instance, a state without income tax may instead charge higher excise, property, or sales taxes.

What do state taxes pay for?

State taxes pay for a variety of public services that are usually more localized. Since states only have to pay for domestic services, as well as taxes occurring at the local level, state taxes are significantly lower than federal taxes. State taxes pay for things like localized healthcare, education, corrections (jail), and transportation.

Pie chart demonstrating what state income taxes fund
Source: Center on Budget and Policy Priorities

As you can see, education, higher education (state universities), and healthcare represent over 50% of tax revenue on a state level.

However, just because you know where your taxes go won’t help you when it comes time to file. If you need some extra help filing your federal or state taxes, take a look at some of the tax preparation software below.

Fun Fact

Sometimes, the federal government and the states work together to fund programs. One example of this is Medicaid expansion under the Affordable Healthcare Act. States had the option of “opting” in to receive funds from the federal government that would result in an expansion of Medicaid for their residents.

Although the federal government was helping fund the program, many states rejected the grants out of principle. This is part of the reason healthcare costs and accessibility differ between states.

Local taxes not based on ordinary earned income

Unfortunately, state and federal taxes are not the end of the story. There are various taxes on the state and city level that help fund even more localized public services.

One of the main ways that school districts are funded, for example, is through the collection of property taxes. This is why wealthier districts tend to have better school districts. The property values are high, and thus the revenue derived from property taxes is also high. Taxes collected through property tax are often allocated to just the school district where the property is located.

However, this isn’t the only way local services are funded. Your county or city services, for instance, may receive funding from:

  • Property taxes
  • Sales taxes
  • Payroll taxes
  • Licensing fees (such as those from a hunting license)

Income from investments

The bulk of this article covers taxes on ordinary income derived from business activities or employment. However, the U.S. government taxes investment income differently on both a federal and state level.

Interest and unqualified dividends

Interest and dividends are taxed as ordinary income. The income you receive from working and business activities, as well as interest and dividends from investments, are combined. This final figure is taxed using ordinary income tax rates on both a state and federal level.

Long-term capital gains

The federal government and state governments tax long-term capital gains differently. On a federal level, the capital gains tax rate is correlated to your ordinary income tax rate.

However, states have their own long-term capital gains rates. These differ by state, and just like there are states that have no income tax, there are also states that have no long-term capital gains tax.

Pro Tip

Need an advisor that can help you invest your money? Check out some selections below. You can figure out the state and federal taxes later.

FAQs

Why do I owe more state taxes than federal?

While this rarely happens, it is possible to owe more state taxes than federal. This is based on your own personal situation since federal income tax and state income tax are calculated separately.

For example, Alabama has a standard deduction of $2,500. As the federal income tax standard deduction is $13,850, it’s possible to owe state income tax and no federal income tax.

What states have no income tax?

Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, and Wyoming have no state income tax.

Is it better to pay state or federal taxes first?

Most taxpayers will complete their federal taxes first before filing their state one. That said, there is no hard and fast rule about which to file first.

How do I avoid owing taxes?

If you make an income above certain thresholds, you need to pay taxes on it. For those that have a considerable amount of money, there are all sorts of financial structures that can mitigate a person’s tax burden. It’s best to consult with a tax advisor about your taxes and what you may owe.

Why do I always owe federal taxes?

You don’t always owe federal taxes. If you are below the standard deduction on ordinary earned income and don’t have any investments that could be hit with long-term capital gains, chances are you won’t owe any federal taxes.

Key Takeaways

  • American residents, and even American citizens living abroad, are responsible for paying federal and state taxes.
  • The federal government collects federal taxes to use on public services that the government provides on a national level, such as healthcare and defense. Federal government marginal tax rates are higher than state tax rates.
  • State taxes are used to pay for more localized state government programs and state-level infrastructure. States are also able to fund programs within their states by collecting taxes on a local level.
  • You may also owe taxes on investments at the federal and state levels. State income tax laws and federal income tax laws state that dividends and interest are to be taxed as ordinary income. In terms of long-term capital gains, states also have different rates than the federal government.
View Article Sources
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  2. Policy Basics: Where Do Our State Tax Dollars Go? — Center on Budget and Policy Priorities
  3. Policy Basics: Where Do Our Federal Tax Dollars Go? — Center on Budget and Policy Priorities
  4. Is Taxation Theft? A Look at the Ethics of Federal Taxes — SuperMoney
  5. What Is FIT Tax? — SuperMoney
  6. What To Do If You Still Haven’t Received a W-2 — SuperMoney
  7. What is Unearned Income? Definition and Examples — SuperMoney
  8. 10 Common Mistakes When Filing Your Taxes — SuperMoney
  9. How to Get Free Tax Help — SuperMoney
  10. IRS Letters and Notices: What To Do If You Got One — SuperMoney
  11. Optima Tax Relief — SuperMoney
  12. Best Tax Preparation Firms — SuperMoney