Monday, November 22, 2010

Why Your State Income Tax Bill Could Change In 2011

Republican gains in states could mean an end to new millionaire taxes and possibly rate cuts.

Do you know if your state income taxes are going up or down next year? The results of the midterm elections provide some clues and one clear answer--wealthy residents of no-income-tax Washington State won't be facing a new tax, since voters there nixed a ballot initiative, backed by Bill Gates Sr. (and his son Bill Gates, the cofounder of Microsoft ( MSFT - news - people )) that would have imposed a 9% tax on income over $1 million per couple. (The initiative was opposed by Microsoft itself, Microsoft CEO Steve Ballmer, ( AMZN - news - people ) CEO Jeff Bezos, and such major corporations as Boeing ( BA - news - people ) and Weyerhaeuser ( WY - news - people ).)

Clues as to what might be in store for tax rates elsewhere come from Republicans' sweeping gains in state capitols and from the promises of some of the governors-elect. Pay close attention if you're thinking of retiring to another state, if you live in a multistate metropolis, or if you're self-employed, independently wealthy, or otherwise have options as to where you live. Before you make any retirement moves, check out the special rates some states offer retirees. For more tips for tax refugees, click here.

-- Maine's Republican Governor-elect Paul LePage has said he'd like to cut the state's top income tax rate from 8.5% to 5%. (Maine's legislature flipped from Democratic to Republican too.)

--Illinois incumbent Democratic Governor Pat Quinn (who narrowly beat Republican Bill Brady) is calling to increase the state's flat 3% income tax, but Democratic House Speaker Michael Madigan is skeptical that a tax hike has enough support to pass.

--Minnesota Democratic Governor-elect Mark Dayton (unless a pending recount reverses the results) ran on a platform of higher taxes, saying in his campaign ads, "We're going to make the rich pay their fair share of taxes." That's despite the fact that Minnesota, with a top rate of 7.85%, is already on Forbes' list of the highest state income tax rates for 2011.

To be sure, Dayton's tax the rich rhetoric echoes what's happened in other states during the last three years of state budget crisis and tax hikes. Just this past January, Oregon voters approved (over the opposition of Nike ( NKE - news - people ) founder Philip Knight) an increase in the tax on income over $500,000 per couple from 9% to 11%.

But with Republicans increasing their control of both governorships and state houses (they will have single party control in 20 states), that trend has likely peaked.

"In light of the election results, with more Republicans controlling state legislatures you're more likely to see spending cuts rather than tax increases," in the coming year, predicts Jamie Yesnowitz, a senior manager in Grant Thornton's state and local tax group in Washington, D.C.

Still, Yesnowitz notes, some East Coast states with temporary millionaires' taxes, could extend them for additional years. In Maryland, where Democrats control the governor's mansion and the statehouse, a millionaire's tax expires at the end of this year. New York's millionaires' tax expires at the end of 2011. There, Democrats will control the governorship and the house, with control of the state senate still up in the air.

On the other hand, New Jersey's wealthiest residents got a reprieve when Republican Gov. Chris Christie in May vetoed the legislature's attempt to put in a 10.75% top rate for incomes above $1 million for 2010. (New Jersey had a one-year rate increase in 2009 with a 10.25% rate on incomes over $500,000 and a 10.75% rate on incomes above $1 million, signed into law by Democratic Gov. Jon Corzine.)

That leaves New Jersey with a top 8.97% rate on income over $500,000 for all filers for both 2010 and 2011, the same rate as in neighboring New York State. "People are always looking to leave New Jersey and New York," says Wayne Berkowitz, a CPA with Berdon LLP in New York City. "There isn't much you can do other than leave."

Just how high state politicians set their top income tax rate is a bit of a psychological game--played the same way retailers like Wal-Mart ( WMT - news - people ) set prices at $45.99 or folks selling their homes list them at $499,000. Often, they're trying to stay just below a round number or below a neighbor's rate.

In the case of Minnesota's Dayton, he has said he would go up to 10.9%, just shy of Hawaii and Oregon's top rate of 11%. "We wouldn't have to bear the burden of saying 'We're the highest,'" observes Phil Krinkie, president of the Taxpayers League of Minnesota. (Not that Krinkie approves of a rate hike.) In any case, Dayton will have to contend with a newly Republican-controlled legislature.

State politicians keen on bringing down rates without losing too much revenue might look to outgoing Rhode Island Gov. David Carcieri's playbook. The Republican reduced the state's top rate from 9.9% to 5.99% as of Jan. 1, and simplified things by replacing five brackets with three. That took Rhode Island off our dreaded top 10 list for 2011.

"Rhode Island needs to be competitive with our neighbors," Carcieri told Forbes. For folks making between $75,000 and $100,000, the new effective rate is about 4%, so that compares favorably with Massachusetts, with its flat tax at 5.3%. The trick? Carcieri brought down rates by broadening the state's tax base--cutting the number of tax credits and limiting itemized deductions.

But don't expect any reform plan--or tax cut--to be easy or to be passed without some trade-offs. "Getting any tax cut through this year was a battle," says Carcieri. And he did make compromises. "If I were to wave a magic wand, in addition to the income tax changes I would have eliminated the estate tax and the capital gains tax,'' he says. Instead, the reform package (which will cut state revenues by a modest $40 million a year) only raised the state estate tax exemption amount from $675,000 to $850,000, and it also retained Rhode Island's capital gains tax at ordinary income rates. (Rhode Island was one of a few states that gave preferential treatment to capital gains; the capital gains tax rate for 2008 was 1.67%; it was set to expire in 2009 but the legislature set the capital gains tax rates to match ordinary income rates instead.) Capital gains will be taxed next year at the same top 5.99% rate ordinary income.

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