April 15, 2013 — For a significant percentage of retirees, finding a tax-friendly location to retire is very important. But, while indeed there are many states and localities that are very tax friendly, making a decision based simply on someone’s list of low tax states could lead you to a poor choice. Tax friendliness varies considerably by state and locality, and how your personal situation interacts vs. those taxes has a huge impact. This is Part 1 of a 2 part series: In this article we will explore the various kinds of taxes that might affect you as a retiree; Part 2 is “Finding a Tax Friendly State for Retirement: A Checklist“, and it features a helpful checklist for you to evaluate your tax situation vs. states you might be considering for retirement. See also this MarketWatch article on “Tax Friendliest States” for a slightly different perspective.
Major Taxes in Retirement
The major state taxes you need to be concerned about are property taxes, income taxes, sales taxes, estate and inheritance taxes, and how your pensions, IRA distributions, and social security will be taxed. All of these factors need to be considered together for your particular situation. You should also be concerned about local differences – cities in many states (e.g.; New York City) charge significant sales and income taxes beyond what the state levies, and property taxes can vary within a state. This article is meant as general guidance – it is not meant to be a definitive statement on exactly how all of the states tax all of these components – there are way too many states and they change their rules too frequently!
Income Taxes. There are 7 states that have no income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Tennessee and New Hampshire only tax certain amounts of dividend and interest income. Income tax rates (and marginal rates) in the rest of the states can differ widely. For example in California the marginal tax rate is 8% for incomes above $46,766, and 10.3% above $1 million, whereas PA has a flat tax rate of 3%.
Property Tax. Property tax is often the the most burdensome one for retirees. These taxes are based on the worth of your home, but they bear no relation to your income or ability to pay. Take the example of Warren Buffett, reportedly the 3rd richest man in the world. He lives in the same house he bought for $31,500 in 1958 (now appraised at $700,000). The City of Omaha collects the same amount of property taxes on that home as from any other similarly valued house – even if owned by a retired person who is living on a vastly smaller income.
Most, but not all, southern states have low property taxes, whereas the old industrial states of the northeast and midwest tend to have high property taxes. Louisiana has the lowest and New Jersey the highest property taxes in the nation. For example as reported by tax-rates.org for 2012-2013, the median property tax paid in Louisiana was $243 (.18% of appraised value), whereas in New Jersey it was $6,579 (1.81%). Of course the value of homes is much higher in New Jersey, as is household income. Some states have ambitious programs to try to protect seniors and others from exorbitant property tax increases. California is one of those. Florida’s Save Our Homes law is extremely popular – it limits increases in the appraised value of primary homes owned by permanent residents to the cost of living or 3%, whichever is less.
Taxation of pensions. This area of taxation is extremely complex and all over the map, depending on the source of the pension and where you decide to live. Particularly if you are going to receive a sizable pension, it can have a big impact on your finances. Many states exempt some or all federal, state, and local government pensions from state income taxation – those include Alabama, Hawaii, Illinois, Kansas, Louisiana, Massachusetts, Mississippi, New York, and Pennsylvania (plus, see above for the 7 states that have no state income tax at all). In Michigan these exemptions are being phased out; whereas Georgia is going in the opposite direction – it will gradually phase out taxation of pension and social security income. More than half of all states exempt all or most income from military pensions. Five states allow no exemption for pensions of any kind: California, Connecticut, Nebraska, Rhode Island, and Vermont. Caution: the states frequently change their rules on pension taxation. Before you make a retirement decision based on this factor, check with the individual state tax website as well as a qualified professional. Here is a link to a CCH chart with capsule summarizes of state by state taxation of social security and pension income.
Distribution of 401k and IRAs. This can be a very important taxation consideration for retirees who have significant balances in these accounts. Unfortunately, state taxation of these distributions is often overlooked. In the year after you turn 70 and 1/2 you must start taking Minimum Required Distributions from your IRA or qualified employee plan such as a 401k. The amount you must take out each year is based on your remaining life expectancy. The required IRS distribution percentage starts at 3.65% at age 70 and goes to 15.87% at age 100. These distributions are treated as ordinary income for federal purposes, but their treatment can vary by state. The majority of states with income taxes include these distributions as income, whereas some like Pennsylvania exclude it.
Taxation of Social Security. The majority of states do not tax social security income. Thirteen states tax either part or all social security payments. Those states are Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Vermont, West Virginia, and Utah.
Sales Tax. There are big differences between states, with some charging none at all (Alaska, Delaware, Montana, New Hampshire, and Oregon) – while others have whopping tax rates. Some states exempt food and clothing, others do not. Many counties and municipalities, such as New York City, tack on their own sales tax.
Estate and Inheritance Taxes. As of July 1, 2013 there will be 12 states that have estate taxes on top of the federal estate tax. A few other states have inheritance taxes (paid by your heirs on what they receive from your estate). Some states, such as New Jersey, have both. See the Topretirements article, “Best States to Die In” for more details.
As you can see some states are more tax-friendly than others. But the answer for you might not be as simple as a list of the lowest tax states – you need to evaluate your particular situation for the states you are considering. For example, if you have a military pension, you might want to consider a state that won’t tax it – all other things being equal. But if you have no income other than social security or an exempt pension, then relax – an income tax is of no bearing to you. A state might have low taxes for working age people, but not necessarily for retired folks (or vice versa).
In general the states with the lowest overall state tax burdens for retirees are:
Taxes are not always the whole story though. Consider Alaska, which has almost no taxes and actually pays residents an annual dividend to live there. But, because it is so cold and remote, Alaska is one of the most expensive places you can live. Family and friends should be more important than taxes. If your children and friends live in a high tax state, moving far away from them just to save money on taxes might make you miserable.
Watch for Part 2: 10 Considerations to Keep in Mind When Choosing a Low Tax State for Retirement
For further reading
“Finding a Tax Friendly State for Retirement: A Checklist”
“20 Most affordable Places to Retire”
Topretirements state retirement guides
IRS Minimum IRA Distribution Worksheet
Retirement Friendly States: These States Want You to Retire There
Comments? What is your experience with state taxes and your choice of where to live in retirement? Please share your thoughts, goals, and experiences on this topic in the Comments section below.