State Tax Reciprocal Agreements (aka "Reciprocity") – Part I
The first time I tried to say reciprocity, which I assumed was a horrible misspelling of a real word, it came out of my mouth as "reci-pro-whuuaaah?" You know, the Scooby Doo sound.
Fortunately, reciprocity is much easier to explain than it is to pronounce. To illustrate, let’s start with an income tax situation involving two states that do not have reciprocity.
Joan is a full-time New Mexico resident who works in neighboring Colorado. Like most states, the Colorado Department of Revenue requires employers to withhold state income tax from their employees’ wages.
So every January, Joan receives her W-2 form from her Colorado employer, which shows her Colorado wages plus the amount of Colorado income tax withheld from her wages. Accordingly, Joan files a nonresident state return for Colorado, where she works, plus a resident state return for New Mexico, where she lives.
Because the two states do not have reciprocity, Joan’s income will be taxed by the state it was earned in (Colorado) at Colorado tax rates. On her New Mexico return, she will take a credit for the tax she paid on her Colorado income. (Otherwise, she’ll be double-taxed, and that’s a no-no.)
Now, let’s pretend…
… that Colorado and New Mexico have a reciprocal agreement. (They don’t! Remember, we’re just pretending.) How would that change Joan’s filing situation?
Well, for starters, Joan wouldn’t have to file a nonresident Colorado return anymore. She would declare her Colorado wages on her New Mexico return, which would be taxed at the New Mexico tax rate. And the reverse would be true for Colorado residents who work in New Mexico.
Oh, and I forgot to mention the best part. Joan no longer needs to purchase TurboTax State software for Colorado — all she needs is the New Mexico program. Isn’t reciprocity great?
This fictional example shows you the basic principles underlying reciprocity. But in real life, things aren’t always that simple (yep, you knew I was going to say that sooner or later). So in Part II, coming soon, I’ll touch upon a real-life example involving the reciprocal states of New Jersey and Pennsylvania.