California vs. Federal Taxes: Where the Rules Differ

Your California return starts with your federal numbers, but it does not end there. California has not adopted many federal tax rules, including most of the 2025 federal tax law. Every difference is an adjustment on Schedule CA (540), and each one is a place where a rushed return leaves money on the table, or claims something the state does not allow.

Here are the differences that come up most often on Bay Area returns.

1. Income California Does Not Tax

Some income that is taxable on your federal return is subtracted on your California return.

• Unemployment compensation
• Paid Family Leave benefits
• Social Security benefits, even the portion taxed federally
• California lottery winnings (winnings from other states’ lotteries are taxable)
• Your state income tax refund
• Interest on U.S. Treasury bills, notes and bonds

Tip:
These subtractions are easy to miss if your return is prepared by simply copying federal numbers across. Check that each one that applies to you appears on Schedule CA.

2. Income California Taxes That the IRS Does Not

It works the other way too.

• Health savings accounts. California does not recognize HSAs. Contributions made through payroll (Form W-2, Box 12, code W) are added back to your California wages, a federal deduction for your own contributions is not allowed, and interest and investment earnings inside the account are taxable by California each year.
• Out-of-state municipal bonds. Interest on bonds from other states is tax-free federally but taxable in California.

Bay Area Consideration:
If you invest your HSA, keep the year-end statements. The dividends and gains inside it have to be reported on your California return even though no federal form shows them.

3. A Much Smaller Standard Deduction

California’s standard deduction for 2025 is $5,706 for single filers and $11,412 for joint filers, compared with $15,750 and $31,500 federally.

Why it matters: many people who take the federal standard deduction should still itemize on their California return. Mortgage interest and property tax alone often exceed the California amount.

4. Itemized Deductions Work Differently

• State income tax: deductible federally (within the SALT limit), but not on the California return.
• Property tax: the federal cap on state and local taxes, $40,000 for 2025, does not apply in California.
• Mortgage interest: California allows interest on up to $1,000,000 of home purchase debt. The federal limit is $750,000.
• Miscellaneous deductions: California still allows certain miscellaneous itemized deductions above 2% of AGI, such as unreimbursed employee expenses. The federal return allows none.
• Charitable gifts: California limits the deduction to 50% of your federal AGI.

5. The New Federal Deductions Do Not Carry Over

California generally has not adopted the 2025 federal tax law. The new federal deductions for tips, overtime, car loan interest and taxpayers 65 and older reduce your federal tax only. See No Tax on Tips, Overtime and Car Loans? Who Actually Qualifies.

6. No Break for Capital Gains

The IRS taxes long-term capital gains at lower rates. California taxes them at the same rates as wages. This applies to stock sales, RSU shares held after vesting, and any gain on a home sale beyond the exclusion.

7. Estimated Payments on a Different Schedule

California’s estimated tax installments are 30%, 40%, 0% and 30%, not four equal payments, and the threshold for owing them is $500. See Estimated Taxes: How to Avoid the Underpayment Penalty.

8. Smaller Differences That Add Up

• Educator expenses: the federal deduction for teachers’ classroom costs is not allowed in California.
• Foreign income taxes: not deductible on the California return.
• Alimony: the rules depend on the date of the divorce agreement and differ between the two returns for agreements signed from 2019 through 2025.

Final Thoughts

Software handles some of these adjustments, but only if the right boxes are checked and the right amounts are entered. The HSA add-back, the Treasury interest subtraction and the choice to itemize for California only are missed all the time. If you would like a second look at your state return, give us a call.

Sources: California FTB 2025 Instructions for Schedule CA (540); FTB “Deductions”, “Unemployment”, “Social Security” and “Estimated tax payments” pages. California amounts shown are for tax year 2025; the 2026 amounts are adjusted for inflation.