State and Local Income Taxes

State and Local Income Taxes (often abbreviated as SALT) are taxes levied by state, city, or other local governments on the income earned by individuals and corporations within their jurisdiction. Think of them as a second layer of taxation on top of the federal income tax you pay to the central government (like the IRS in the U.S.). Unlike the relatively uniform federal system, the world of SALT is a chaotic patchwork quilt. Some states, like Florida and Texas, have no state income tax at all, while others, like California and New York, have some of the highest rates in the nation. This tax applies not just to your salary but often to your investment profits as well, including interest, dividends, and capital gains. For a savvy investor, understanding how SALT works isn't just an accounting chore; it's a critical piece of the puzzle for maximizing your real, spendable returns. What you keep is just as important as what you earn.

At its core, value investing is about buying great companies at a fair price and letting your wealth compound over time. Taxes are a direct drag on that compounding machine. SALT is a particularly sneaky drag because it varies so dramatically based on one simple factor: your address.

Imagine two investors, one living in tax-free Nevada and the other in high-tax Oregon. They both buy the same stock and sell it a few years later for a $50,000 profit. While both will pay federal capital gains tax, the Nevada investor pays zero state income tax on that gain. The Oregon investor, however, will have to send a chunk of that profit—potentially thousands of dollars—to their state treasury. Over a lifetime of investing, this difference adds up to a staggering amount. Your after-tax return is the only return that matters, and SALT is a major variable in that equation.

It’s not just about your personal taxes. The companies you invest in are also on the hook for state and local taxes. A company headquartered in a state with high corporate income tax rates faces a higher cost of doing business than a competitor in a low-tax state. This directly impacts the company's profitability and earnings, which are the lifeblood of its stock price. When analyzing a company, a diligent value investor should consider its tax environment as part of its overall competitive landscape. A lower tax burden can be a subtle but sustainable competitive advantage.

The rules for state and local taxes can seem complex, but they generally fall into a few main categories. Understanding where your state fits in can help you plan your investment strategy more effectively.

States generally take one of three approaches to income tax:

• No Income Tax: These are the investor havens. States like Florida, Texas, Nevada, Washington, Wyoming, South Dakota, and Alaska do not tax personal income. This includes income from your investments.
• Flat Tax: These states apply a single tax rate to all income levels. States such as Illinois, Indiana, and Pennsylvania use this system. It’s simpler than a progressive system, but the rate can still take a significant bite out of investment gains.
• Progressive Tax: This is the most common system, used by the federal government and states like California, New York, and Oregon. Under this model, the tax rate increases as your income rises. High-earners and those with substantial investment gains often face the highest marginal tax rates.

In the United States, a major recent development was the introduction of the “SALT cap.” Here's the breakdown:

1. The Deduction: For decades, taxpayers could deduct the full amount of their state and local taxes paid (including property and income taxes) on their federal tax return. This federal tax deduction softened the blow for residents of high-tax states.
2. The Cap: The Tax Cuts and Jobs Act of 2017 (TCJA) placed a $10,000 annual cap on the SALT deduction for individuals and married couples.
3. The Impact: For investors in high-tax states, this was a double whammy. Not only do they pay high state taxes on their income and investments, but they can no longer fully deduct those payments to reduce their federal tax bill. This makes the gap in the total tax burden between high-tax and low-tax states even wider.

While you can't wish taxes away, you can be smart about minimizing their impact. A value investor's long-term, patient approach is already a great start for tax efficiency.

• Use Tax-Advantaged Accounts: This is Rule #1. Max out contributions to retirement accounts like 401(k)s and IRAs. Growth within these accounts is tax-deferred or, in the case of a Roth IRA, completely tax-free upon withdrawal. While you'll likely pay state income tax on withdrawals from a traditional IRA or 401(k), shielding your investments from annual taxes on dividends and capital gains allows your money to compound much faster.
• Consider Municipal Bonds: For investors in high-tax states, municipal bonds (“munis”) can be a secret weapon. Interest income from munis issued by your home state and its municipalities is typically exempt from federal, state, and local income taxes. This “triple-tax-free” status can result in a higher after-tax yield than a corporate bond with a seemingly higher interest rate.
• Hold for the Long Term: Patience pays. At the federal level, investments held for more than one year are typically eligible for lower long-term capital gains tax rates. While many states tax all capital gains as ordinary income regardless of holding period, adopting a long-term mindset is a fundamental tenet of value investing that aligns perfectly with tax efficiency. Minimizing trading reduces short-term capital gains, which are almost always taxed at higher rates.