The Declaration of Independence and the Constitution were both signed in Philadelphia, Pennsylvania. The city represents the foundation of American history and it attracts visitors from around the world. What else makes the state so popular? Maybe it’s the opportunities to engage in a variety of experiences—from devouring the best twisted pretzels—when not eating cheesesteaks—to visiting Punxsutawney for Groundhog Day. As a state of many historic “firsts”, the first zoo in America was built in 1874 in Philadelphia. There, you can currently see endangered Amur tiger brothers Wiz and Dimitri, who were actually born one day apart.
The PA state income tax rate is 3.07%, which is lower than state taxes in nearby NY, NJ, and CT. Unlike most other states in the area which have a progressive tax system, PA’s state income tax rate is the same regardless of the amount of income received. Many localities in PA impose an additional tax on earned income at the rate of 1%, but this may vary depending on the locality. Philadelphia residents pay an extra 3.8712% tax on earned income and investment income.
We’ll show you how you can take advantage of PA tax rules for education, retirement, and investments.
First, a reminder: Due to 2017 tax reform, the federal tax deduction for state and local taxes (otherwise known as SALT) is now limited to $10,000 per year. Prior to the implementation of tax reform in the 2018 tax year, there was no dollar limit on the deduction.
This article is intended for purely educational purposes. Betterment is not a tax advisor, nor should any information herein be considered tax advice. Please consult a qualified tax professional.
Saving for your child’s college education might feel overwhelming, especially when you’re trying to prioritize education savings with your other goals in life, such as retirement.
PA makes saving for education a little easier by allowing a $30,000 deduction per beneficiary for married couples who contribute to a 529 plan (or $15,000 for single taxpayers). PA is among a small number of states (AZ, AR, KS, MN, MO, MT) that allow for tax parity, which is a tax benefit for contributions to any state 529 plan. Rinse and repeat—because you can contribute and take the deduction every year.
Ever wonder why so many people retire in Florida? Sunshine aside, moving to Florida is a common strategy for many northeast highly taxed residents because Florida has no income taxes. To encourage Pennsylvanians to retire in their own state, PA allows for a broad retirement income exemption on IRAs and employer sponsored plans, such as 401(k)s and pensions.
Example: A retired married couple who are both age 65 years with a $60,000 annual pension, $30,000 annual IRA distribution, and $40,000 in Social Security benefits, would be fully exempt from PA income taxes.
PA does not allow for pre-tax employee contributions to any type of retirement plan. Employee contributions to Traditional 401(k), 403(b), 457 governmental, Thrift Savings Plan, Traditional IRA, SEP IRA, and Simple IRA accounts are always after-tax for PA state tax purposes. It is a good idea to keep track of these contributions in the event of an early distribution which would only be PA taxable after all employee contributions have been recovered.
Prior to 1984, Social Security benefits were tax-free to all recipients, regardless of how much other income they received. After the 1984 change went into effect, the federal government has expanded the taxation of Social Security benefits to potentially include up to 85% of benefits as taxable income.
PA has taken a generous step to fully exempt Social Security benefits from state income taxes for everyone—regardless of income level.
As a state, PA does not always have the power to choose what income it allows exemptions for. Due to federal law, PA is required to exempt U.S. government interest from income taxes. This tax break also applies to mutual funds and ETFs that invest in U.S. government bonds.
Municipal bonds issued by the state of PA and its municipalities are exempt from PA income taxes. However, interest received on bonds issued by other states and local governments are subject to PA income taxes.¹
PA does not recognize capital loss carryovers. Why is this important? Let’s say you have a $100,000 unused capital loss from a prior year, and a $100,000 capital gain for the current year. The federal government would allow the carryover loss and the gain to offset each other. However, PA would ignore the unused capital loss from last year and the $100,000 gain from the current year would be subject to PA income tax.
Also not recognized by PA is the netting of capital losses between one spouse’s individual account and capital gains from the other spouse’s individual account in the same tax year. Why is this important? Let’s say one spouse has a $100,000 capital loss and the other spouse has a $100,000 capital gain for the current year. PA would ignore the $100,000 capital loss and require the 3.07% tax to be paid on the $100,000 gain. This can be a solvable problem as long as you put in some advance planning. If all assets are held jointly, the current year’s capital losses can offset the current year’s capital gains.
Here are some fun tax facts to tell your fellow Pennsylvanians.
- PA has a reciprocal agreement with six states: Indiana, Maryland, New Jersey, Ohio, Virginia, West Virginia. The agreement allows a PA resident who works in any of these states to “make believe” they never crossed PA state lines, so that they only pay PA income tax on their compensation. The benefits of this agreement include avoiding paying higher state taxes to their work location state, as well as avoiding additional tax software filing fees. If every state had a reciprocal agreement with all of its neighboring states, it might send the tax software business into a tailspin.
- PA adds an 18% flood tax to the sale of every bottle of alcohol. The tax was instituted to fund the recovery of the Johnstown flood in 1936 and still remains today. Once the tax spigot is turned on, it is very difficult to turn off.
- Candy and gum are exempt from sales tax. Good lobbying, Hershey.
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¹ The only exception to this “out of state rule” are for bonds issued by governments who have an exemption per federal law. Examples include Puerto Rico and Guam. Note that Betterment is currently available to residents in Puerto Rico and the Virgin Islands, but we currently do not support residents in Guam.
Betterment is not a tax advisor, nor should any information herein be considered tax advice. Please consult a qualified tax professional.