I work in one state and live in another state. What do I file? And what the heck are State Tax Reciprocal Agreements (aka "Reciprocity")?
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.. Because she earns income in Colorado (us tax savvy types call this “Colorado source income”) her employer withholds Colorado taxes from each paycheck. The fact that she earned Colorado source income also means that she will need to file a Colorado tax return even though she does not live there.
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. She sees “CO” in Box 15, the taxable Colorado wages she earned in Box 16, and the total year’s worth of income her employer withheld in Box 17.
New Mexico also requires Joan to file an income tax return because she is a resident and she earned taxable income (they don’t care whether she earned it in Colorado, New Mexico, or Timbuktu). 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’s W-2 would look a little different. Instead of seeing “CO” in Box 15, she’d see “NM”. This means that her employer is withholding New Mexico taxes instead of Colorado taxes on her earnings, even though she is technically earning Colorado source income.
Even better, Joan wouldn’t have to file a nonresident Colorado return anymore. She would simply file a New Mexico resident return as if she had earned the money in New Mexico 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.