Washington millionaires are not taking advantage of tax deductions, leaving the state with a loss of potential revenue.

If you are a taxpayer in Washington state, you may have recently heard about the new Millionaires Tax. But you might assume that the same itemized deductions you use for your federal income tax return will also apply to your state income tax. Unfortunately, that assumption is incorrect.

In fact, only two of the usual deductions "work" for the state income tax, and even those are limited. This means that your Washington state income tax may end up being much larger than you initially thought, so it's important to plan ahead. It's worth noting that the new state income tax won't go into effect until January 1, 2028.

If you want more background information on the topic, you can find it here: The New Washington State Millionaires Tax. Essentially, the tax has two brackets and two deductions. The first $1,000,000 is taxed at 0%, while anything over that amount is taxed at 9.9%.

The two deductions are for charitable contributions to in-state charities and for gambling losses. But here's where it gets tricky. For federal income tax purposes, taxpayers can choose between using the standard deduction or their itemized deductions, whichever is higher.

However, the Millionaires Tax in Washington works differently. The "standard deduction" is not an alternative to itemized deductions, but more like an exclusion or a zero-percent tax bracket. This means that many of the deductions you are used to when thinking about "taxable income" will not apply.

For example, medical and dental expenses are not deductible for Washington Millionaires Tax purposes. This means that even in a year with significant medical expenses, you can't count on them to lower your taxable income for state taxes. One way business owners can work around this is by providing good medical insurance for themselves and their employees.

The self-employed health insurance deduction can reduce your federal adjusted gross income, which in turn may reduce your Washington taxable income. Similarly, contributions to health savings accounts (HSAs) can also lower your federal adjusted gross income, thus potentially reducing your Washington state income tax. State and local taxes also do not work as deductions for Washington state income tax.

While individual taxpayers can deduct these taxes for federal income tax purposes, the same does not apply for Washington. However, there is a workaround for business owners and investors in pass-through entities. The new law includes a pass-through entity tax that may be beneficial for those who owe a significant amount of state income tax through their partnerships, LLCs, or S corporations.

By properly structuring this tax, it may reduce business income before it reaches the owner's federal adjusted gross income, thus lowering their taxable income for Washington state tax purposes. Another deduction that doesn't apply for the Washington Millionaires Tax is home mortgage interest. This means that if you have a mortgage, the interest you pay on it will not be deductible for state taxes.

This can have a significant impact on your taxable income, as demonstrated by the following scenario: let's say you have $1,000,000 in investments that generate $60,000 in income, and you also have a $1,000,000 mortgage that generates $60,000 in mortgage interest. For federal income tax purposes, these two amounts may offset each other, resulting in no net income. However, for Washington state income tax purposes, only the investment income is taken into account, while the mortgage interest is ignored.

To work around this, you could consider paying off or paying down your mortgage. While this may not provide an economic benefit, it could potentially lower your Washington taxable income and therefore your state income tax. The same issue arises with investment interest.

If you have investments funded with margin debt, you may expect to be able to deduct the interest on that debt for federal income tax purposes. However, for Washington state income tax purposes, this may not be the case. To avoid this issue, you could consider reducing your leverage and paying off the margin debt.

Finally, it's important to note that casualty and theft losses are also not deductible for Washington state income tax purposes. This means that if you experience a loss due to a natural disaster or theft, you won't be able to deduct it from your taxable income for state taxes. In summary, while the new Millionaires Tax in Washington state may seem straightforward with its two brackets and two deductions, there are many nuances and traps that taxpayers should be aware of.

It's important to understand the differences between federal and state taxes and plan accordingly to minimize the impact on your taxable income and state income tax. Attention all taxpayers in the state of Washington! Are you aware of the new Millionaires Tax that you will be paying?

If so, you may have assumed that the itemized deductions you use on your federal income tax return will also apply to your state income tax. However, I am here to inform you that this assumption is incorrect. In fact, only two of the usual deductions actually "work" for the Millionaires Tax, and they are both limited.

This means that your state income tax may end up being significantly higher than you initially anticipated, and it would be wise to plan ahead for this change. It's important to note that this new tax will not go into effect until January 1, 2028. For more information on this topic, please refer to The New Washington State Millionaires Tax.

To better understand this new income tax in Washington, let's break down the key points. Firstly, there are two tax brackets - the first $1,000,000 will be taxed at zero percent, while any amount over that will be taxed at 9.9 percent. Additionally, there are two deductions that apply - one for charitable contributions to in-state charities and one for gambling losses.

So, two brackets, two deductions. Simple enough, right? Well, here's where things get tricky.

For federal income tax purposes, taxpayers have the option to either use the standard deduction or their itemized deductions, whichever amount is higher. However, the Millionaires Tax in Washington works differently. The standard deduction is not an alternative to itemized deductions, but rather an exclusion or a zero-percent tax bracket.

This means that many of the deductions you usually consider when calculating your taxable income will not be available. For example, medical and dental expenses will not reduce your taxable income for Washington's Millionaires Tax. So, even in a year with significant medical expenses, you cannot assume that it will shelter your income from state income tax.

If you are a business owner, one way to potentially reduce your taxable income is to provide good medical insurance for your employees. This will also lower your federal adjusted gross income (AGI), which in turn may lower your Washington taxable income. Similarly, contributions to health savings accounts (HSAs) and individual health insurance policies can also help reduce your federal AGI and therefore your Washington taxable income.

Another deduction that does not work for Washington's Millionaires Tax is for state and local taxes. While you may be able to deduct these taxes for federal income tax purposes, they will not reduce your taxable income for the state tax. However, there is one potential workaround for business owners and investors in pass-through entities.

Washington's new law includes a pass-through entity tax, which can be complex and inflexible. But for those who own interests in partnerships, LLCs, or S corporations and owe large state income taxes, it may be worth looking into as it could potentially lower your business income before it reaches your federal AGI, which would then lower your Washington taxable income. Let's talk about home mortgage interest.

This is another deduction that does not apply to Washington's Millionaires Tax. Unlike for federal income tax purposes, where you may be able to deduct interest on a $1,000,000 mortgage, this is not an option for the state tax. This can lead to some interesting scenarios, such as if you have $1,000,000 of investments generating $60,000 of income and a $1,000,000 mortgage with $60,000 of interest.

For federal taxes, these amounts would essentially cancel each other out, resulting in no net income. However, for Washington's Millionaires Tax, only the investment income would be taken into account, and the mortgage interest would not. One possible workaround for this is to pay off or pay down your mortgage.

While this may not seem like a financially beneficial move, it could potentially lower your Washington taxable income and result in less state income tax. It's important to note that this applies even for those with grandfathered mortgages, as Washington does not allow for a regular mortgage interest deduction. Lastly, let's touch on investment interest.

Just like with home mortgage interest, this is not a deduction that applies for Washington's Millionaires Tax. So, if you have investments funded with margin debt, the interest expense will not be taken into account for the state tax, even though it may be deductible for federal taxes. This could potentially lead to a higher taxable income for Washington and result in a higher state income tax.

The best course of action here would be to de-leverage and reduce your margin debt, as borrowing to hold investments becomes less attractive when the income counts for Washington tax purposes, but the related interest expense does not. I hope this has shed some light on Washington's new Millionaires Tax and how it may affect your taxable income and deductions. As always, it's important to plan ahead and be aware of any changes in tax laws that may impact you.

Stay informed and make wise financial decisions for a smoother tax season.