Did you know that if you earn income in a state, you may be liable for that state's personal income taxes even if you don't live in the state?
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That's right. Income earned by non-residents can still be taxable.
If you live out of state, you typically need to file a non-resident income tax return with the state. You will then have to pay those taxes too!
Unfortunately, you will still have to file income taxes in the state where you reside, but the good news is that you usually will get a credit for income taxes paid to other states.
In other words, you won't have to pay taxes twice, to two states, for the income you earned outside of your state of residence. The tax system may be out of control, but it's not that out of control.
The exception to all of this is when a state has a reciprocal agreement with a neighboring state.
Let's say an employee works full-time in Wisconsin but live in Illinois, just south of the Wisconsin border.
Illinois and Wisconsin have a reciprocal agreement, so what does that mean for the employee?
It means that Wisconsin is fine with the employee not filing income taxes in Wisconsin. They only need to file income taxes in Illinois, the state where they live.
Of course, Wisconsin benefits in an alternative scenario in which an employee lives in Wisconsin and works in Illinois. In that case, the employee files for incomes taxes in Wisconsin, and Wisconsin benefits from the work that was done in Illinois.
Similarly, Michigan has a reciprocal agreement with Illinois. So, that means that Michigan residents don't have to pay Illinois income tax or file an Illinois income tax return on compensation paid in Illinois.
In short, if two states have a reciprocal agreement, it means an employee is only subject to the income tax in the state where he lives.
If he or she works out of state, there is no tax obligation for the state where the employee actually works.
Now that you get the basic idea behind reciprocal payroll tax agreements, you probably have a couple of questions.
First, what are the implications of reciprocal income tax agreements to small business owners who are tasked with the joyful job of processing payroll and withholding income taxes for their employees. For example, does an Illinois employer have to withhold Michigan payroll taxes for an employee that lives in Illinois. We cover that issue in our article on Withholding for Employees Subject to Reciprocal State Agreements.
Second, as an entrepreneur, you need to be aware of which states your own state has reciprocal agreements with. We cover that topic in our State Income Tax Reciprocal Agreements article.