Reciprocal Agreement

A reciprocal agreement, in state income tax, is an arrangement between two states providing that a resident of one who earns wages in the other is taxed on those wages only by their home state. New Jersey's statute describes the power from the states' side: its Division of Taxation "may enter into an agreement with the taxing authorities of any state which imposes a tax on or is measured by income to provide that compensation paid in such state to residents of this State shall be exempt from such tax; in such case any compensation paid in this State to residents of such state shall be exempt from New Jersey personal income tax," and may provide in those agreements "for reciprocal withholding, employer liability, exchange of information and all other matters relating to cooperation between the states."

The phrase is generic on its own, and two states can have reciprocal arrangements about all sorts of things. This page is about the income tax version, which is what a commuter who lives on one side of a state line and works on the other will meet. Remote work taxes covers the wider problem this is one answer to, including the resident credit that applies where no agreement exists.

The mechanism is a certificate the employee files, which is why so many eligible people never get the benefit. Illinois publishes Form IL-W-5-NR, titled "Employee's Statement of Nonresidence in Illinois," and its instructions are direct: "You must complete Part 1 of this form if you are a resident of Iowa, Kentucky, Michigan, or Wisconsin ... and your wages are exempt from withholding of Illinois Income Tax under the reciprocal withholding agreements between Illinois and these states. You must file your completed Form IL-W-5-NR with your Illinois employer." New Jersey's equivalent is Form NJ-165, "Employee's Certificate of Nonresidence in New Jersey." Nothing happens by itself. An eligible commuter who never files the form has the work state's tax withheld all year.

The employer carries a matching obligation. Illinois tells employers: "You are required to have a copy of this form on file for each employee who is a resident of Iowa, Kentucky, Michigan, or Wisconsin; receives compensation paid in Illinois; and elects to claim exemption from withholding of Illinois Income Tax under the reciprocal withholding agreements." The certificate is a payroll record, not a filing with the state.

A short deadline sits inside the Illinois form and is easy to miss. "If you change your state of residence, you must notify your employer within ten days." Moving across the line in either direction changes which state's tax should be coming out, and the duty to say so rests on the employee.

The agreement covers wages and nothing else. The New Jersey Division of Taxation states it flatly about the Pennsylvania arrangement: "The Reciprocal Agreement covers compensation only. If you are self-employed or receive other income (ie., gain from the sale of property) that is taxable in both states, you must file a New Jersey nonresident return and report the income received." It also defines what compensation means for this purpose: "salaries, wages, tips, fees, commissions, bonuses, and other payments received for services rendered as an employee." A commuter with a rental property or a side business in the work state is still exposed there.

If tax was withheld anyway, the money is recovered by filing, not by asking payroll. New Jersey's guidance for a Pennsylvania resident who had New Jersey tax withheld is to file a New Jersey nonresident return to get a refund, and to file Form NJ-165 with the employer to stop the withholding going forward. The certificate is prospective.

A second, unrelated exemption often rides on the same form. Illinois Form IL-W-5-NR also serves a service member's spouse claiming exemption under the Military Spouses Residency Relief Act, which reaches a different set of people for a different reason. Meeting either test uses the same piece of paper, which is worth knowing because a reader searching for one may find the form described in terms of the other.

There is no register of state pairs, and that absence is the practical point. These are agreements between two revenue departments rather than federal law, so they are added, amended and ended without any central listing, and a table copied from anywhere becomes wrong quietly. The reliable question is not "which states have reciprocity" but "does the state my employer is in publish a certificate of nonresidence, and does it name my home state on it." That is a page on one revenue department's website, and it is current by construction.

The steps for a commuter.

1. Identify the two states. The state of residence and the state where the work is physically performed.

2. Check the work state's revenue department for a certificate of nonresidence, and check whether it names the home state.

3. File the certificate with the employer, not with the state. The employer keeps it on file and stops withholding the work state's tax.

4. File one resident return in the home state covering the wages.

5. Tell the employer within the stated deadline if you move. Illinois gives ten days.

A hypothetical example. Bethany lives in Wisconsin and works in Illinois for $60,000 of wages. Suppose Illinois withholding on those wages would come to $2,700 for the year, and her Wisconsin tax on the same wages is $3,300. Both figures are stipulated for the illustration.

Without the certificate on file, Illinois withholds the $2,700 through the year. Because the reciprocal agreement means Illinois has no right to tax the wages of a Wisconsin resident, she files an Illinois nonresident return to recover the whole $2,700, and a Wisconsin resident return on which she pays $3,300. Her total for the year is $3,300, but she has filed two returns and had $2,700 sitting with the wrong state for up to sixteen months.

With the certificate on file from her first day, no Illinois tax is withheld, she files one Wisconsin return, and pays the same $3,300. The agreement did not change what she owed by a dollar. It changed how many states she dealt with and when she had her money.

What it does well

• It removes the second state's claim outright, so there is one return rather than two and no credit to compute.
• It stops the wrong state's tax at source rather than refunding it a year later, which matters most to the people for whom a year of withheld tax is real money.
• It is administratively cheap: one form, filed once with the employer, kept as a payroll record.
• Where the two states' rates differ, a commuter simply pays their home state's rate, with none of the higher-of-the-two outcome a credit can produce.

Limits and traps

• It is opt-in, and an eligible employee who never files the certificate gets none of the benefit.
• It covers compensation only. Self-employment income, rental income and gains taxable in the work state stay taxable there, and still require a nonresident return.
• It exists only between specific pairs of states, and only those states' revenue departments publish the current position.
• The certificate is prospective, so tax already withheld comes back through a nonresident return rather than through payroll.
• A change of residence has to be reported to the employer quickly, and an employee who moves and says nothing has the wrong state's tax withheld for as long as the silence lasts.