How Kentucky income tax works: federal AGI, a $3,360 deduction, 3.5%, and the local payroll tax

Kentucky’s income tax is a flat 3.5% for 2026, down from 4% in 2025, on a base that starts with federal adjusted gross income. From AGI the state adds a few items, subtracts a few more, takes off either a $3,360 standard deduction or the deductions on its own Schedule A, and multiplies the rest by 3.5%. A handful of credits follow, the largest of which, the Family Size Tax Credit, can wipe the tax out for a low-income household. That is the whole state return. The second tax is the one that catches newcomers: most Kentucky cities and counties take an occupational license tax of roughly 0.5% to 2.5% out of every paycheck earned inside their borders, and nothing on Form 740 gives any of it back.

Who files, and the filing status that matters

A full-year resident files Form 740 and reports all income, wherever earned. A part-year resident or a nonresident with Kentucky income files Form 740-NP. A resident of Illinois, Indiana, Michigan, Ohio, Virginia, West Virginia or Wisconsin whose only Kentucky income is wages files nothing under the reciprocal agreements, or Form 740-NP-R to recover withholding; see Moving to Kentucky.

Form 740 offers four filing statuses: single; married filing separately on this combined return; married filing a joint return; and married filing separate returns. The second one is the Kentucky peculiarity: both spouses on one return, one in Column A and one in Column B, each taxed as a separate person. Since the standard deduction is one $3,360 per column and a joint return gets only one, nearly every two-income couple files the combined return; a hand-prepared joint return often leaves $118 of tax on the table. There is no head-of-household status; a federal head of household files as single here.

Where it starts: federal AGI

Line 5 of Form 740 is federal adjusted gross income, line 11 of the Form 1040. Everything the federal return does after AGI is invisible here: the federal standard deduction, itemized deductions, the $6,000 senior deduction, the new deductions for tips, overtime and car-loan interest, and the qualified business income deduction. House Bill 757 made the point explicit in 2026, adopting the Internal Revenue Code as of December 31, 2025 and carving the tips, overtime and car-loan deductions back out; a server who owes no federal tax on $8,000 of tips still owes Kentucky $280 on them. A federal adjustment taken above the line, an IRA deposit, an HSA contribution, half of self-employment tax, flows straight through and cuts Kentucky tax too. Schedule M then asks two questions: what did the federal return leave out that Kentucky taxes, and what did it include that Kentucky does not.

Additions. Interest on other states’ municipal bonds, tax-exempt federally but taxable here (Kentucky’s own stay exempt). Federal bonus depreciation and the enlarged Section 179 expensing, which Kentucky has refused since 2001; a landlord, farmer or sole proprietor adds them back on Schedule M line 3 and computes Kentucky depreciation on a Kentucky Form 4562, with Section 179 capped at $100,000 for property placed in service since 2020 ($25,000 before) (verify). A federal net operating loss deduction, because Kentucky runs its own on Schedule KNOL. For most wage earners there is nothing on this list.

Subtractions. This is where Kentucky gives money back, and the two biggest lines belong to retirees.

There is no subtraction for 529 contributions, unemployment compensation or capital gains. All three are taxed in full at 3.5%.

AGI plus additions minus subtractions is Kentucky adjusted gross income, Form 740 line 9. The next step is Kentucky’s own.

The deduction: $3,360, or Kentucky Schedule A

The standard deduction for 2026 is $3,360, up $90 from 2025; the Department of Revenue announced it on September 4, 2025, and has already set 2027 at $3,470. It is the same for every filing status and every age, with no extra amount for 65 or blindness, and a joint return does not get two.

The alternative is to itemize on Kentucky Schedule A, and the Kentucky choice is independent of the federal one. A household that takes the $32,200 federal standard deduction can itemize for Kentucky, and because the hurdle is only $3,360, most homeowners with a mortgage should.

If one spouse itemizes on a combined return, the other must too, so the comparison is two standard deductions, $6,720, against the couple’s combined Schedule A. Gambling losses are the quiet surprise: a federal non-itemizer can deduct them for Kentucky, up to winnings.

The rate: 3.5%, and why it is staying there

Kentucky adjusted gross income minus the deduction is taxable income, line 11; no exemptions follow, since Kentucky abolished them in 2018. Taxable income times 3.5% is the tax, line 12. Wages, interest, dividends, capital gains, rent, unemployment, gambling winnings and the taxable part of a pension are all taxed at the same rate; there is no preferred rate for gains. The rate was 4% for 2024 and 2025 and fell to 3.5% on January 1, 2026 under House Bill 1 of 2025. It stays at 3.5% for 2027: revenue missed the trigger for the next half-point cut by more than $1 billion for fiscal 2026, and the Department cannot lower the rate without the General Assembly. The 2026 withholding tables already use 3.5%.

The credits

Kentucky’s credits are nearly all nonrefundable: once the tax is gone the rest is lost. The exception is the credit for a business owner’s share of the pass-through entity tax, refundable since 2025.

No earned income credit, no child tax credit, no property tax or renter’s credit, nothing for 529 contributions. The Family Size Tax Credit is the one that decides whether a low-income household owes anything: a single parent with two children and $26,000 of wages owes Kentucky nothing. It is worked through in Credits and breaks for Kentucky families.

The other tax: occupational license taxes

Kentucky cities, counties and some school districts may levy a license tax on the privilege of working or doing business inside their boundaries, and most do. As of 2024, 86 of the 120 counties taxed payroll, at 0.5% to 2.25% with a median of 1%, and cities add their own. Louisville Metro takes 2.2% from residents who work in the Metro and 1.45% from nonresidents who work there; Lexington-Fayette takes 2.25%. The tax applies to wages, salaries and the net profit of a business; it does not touch pensions, Social Security, interest, dividends or capital gains.

Four things to know. It is withheld by the employer and shows in Box 19 of the W-2. It follows where the work is done, not where you live. There is no credit for it on the Kentucky return and no state-level form; the self-employed file a net-profit return with each city or county where they earned it, Form OL-3 in Louisville. And the reciprocal agreements with neighboring states cover state income tax only, so an Indiana resident working in Louisville still pays Louisville, and a Kentucky resident working in Cincinnati still pays Cincinnati.

Withholding and estimated payments

Kentucky withholding is figured by formula, not by allowances: annualized wages minus $3,360, times 3.5%, divided by the number of paychecks. Form K-4 lets an employee claim exemption or ask for extra withholding. Because the formula builds in one standard deduction per job, a person with two W-2s gets the deduction twice in withholding but once on the return; the Department suggests an extra $117.60 of withholding for the year to cover it.

Anyone who expects to owe more than $500 after withholding and credits must make estimated payments on Form 740-ES, due April 15, June 15, September 15 and January 15. For 2026 Kentucky rewrote its penalty rules to mirror the federal ones: pay in at least 90% of this year’s tax or 100% of last year’s, in timely installments, and there is no penalty; Form 2210-K now has the federal annualized income method. The people caught are landlords, the self-employed, retirees with pensions above the $31,110 exclusion and no Kentucky withholding, and anyone with a large capital gain.

How to file

The 2026 return is due April 15, 2027. A federal extension on Form 4868 extends the Kentucky return automatically; without one, Form 740EXT gives the same six months. The extension is to file, not to pay: tax not paid by April 15 draws interest and a late-payment penalty of 2% per 30 days, up to 20%, unless at least 75% of the tax was paid on time. The state’s own free system, KY File, handles any income but offers no guidance and pays refunds by paper check only; the Free File vendors on the Department’s site are free for incomes up to about $69,000 (verify). An e-filed return with direct deposit is usually paid in two to four weeks. The dates and forms are in Kentucky calendar and forms.

What trips people up

• A joint return when the combined return would have given a second $3,360.
• Taking the Kentucky standard deduction when mortgage interest alone beats it. Kentucky Schedule A does not care what you did federally.
• The federal tips, overtime or senior deduction expected to lower Kentucky tax. None of them reach Form 740.
• The gross 1099-R left in income with no $31,110 exclusion on Schedule M, or one spouse’s exclusion used on the other’s pension.
• A reciprocal state’s withholding claimed as a credit on Schedule ITC. It is refunded by that state instead.