Now that it’s summertime, you and your family may be embarking on a long-awaited road trip. But have you ever thought about relocating – for good – when you retire? Such a move might make your retirement less “taxing.”
During your working years, you save and invest to eventually enjoy a comfortable retirement. But once you do retire, your focus will shift from building assets to making them last. Taxes can play a huge role in how long your retirement assets last, and that is why many people choose to move to a state with tax policies that are more favorable to retirees.
Before you call the moving company, however, you’ll want to do some research – because choosing a “low-tax” state is not quite as simple as it sounds.
What’s taxed? What isn’t?
Currently, seven U.S. states – Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming – have no state income tax. In addition to these seven states, New Hampshire and Tennessee tax interest payments and dividends, but not wages, earnings, or other forms of income.1
To understand the range of state income taxes, compare these states to California. The Golden State’s top marginal tax rate is 13.3%. Illinois, a mid-range state in terms of taxes, has a flat rate of 3.75% (although this rate may go up as Illinois looks to address its budget problems).2
You might think, then, that if you want to live in a low-tax environment, you just have to relocate to one of the states that doesn’t have an income tax. When reviewing a state’s tax situation, however, you need to look at all the types of income that contribute to your retirement income stream. Will your Social Security benefits be taxed? How about pension payments? What about withdrawals from your traditional IRA, 401(k), or other tax-advantaged retirement plans?
There’s no uniform answer to all these questions. For starters, 37 states, including the no-income-tax states mentioned above (and Illinois), don’t tax Social Security benefits. The other 13 states do tax these benefits to some extent, either by following the federal government’s formula – counting up to 85% of benefits as taxable income – or by using other methods, such as taxing benefits above certain income limits.3 So, when it’s time to decide where you want to live during retirement, you will want to familiarize yourself with a state’s rules on taxing Social Security benefits, particularly if Social Security is going to be a major part of your retirement income.
On the other hand, if Social Security will only be one component of your retirement income, and you plan to rely heavily on withdrawals from your IRA and 401(k), or payments from a pension, you will want to study different states’ rules on taxation of these income sources – because these rules can vary considerably. For example, state and local government pensions are fully tax-exempt in some states, while other states offer a partial tax exclusion. And some of the states that don’t tax these public pensions will tax pensions earned from a private employer.
The state-by-state situation is also diverse when it comes to taxation of traditional IRAs, 401(k)s, and other “defined-contribution” plans. Many states, including Illinois, don’t tax IRA and defined-contribution plan withdrawals at all, and even some of the generally “higher-tax” states offer partial exemptions. But in a few states, these withdrawals are taxable at ordinary income tax rates.
Thinking beyond income taxes.
Even after you’ve looked at how different states deal with all these sources of income, though, you still need to consider other tax-related issues. Keep in mind that states offering tax breaks in some areas still need to raise revenue, so they may impose relatively high sales taxes or property taxes, as well as higher fees on things like vehicle registration.
Finally, don’t forget about estate taxes. About one-third of the states impose an estate or inheritance tax. While these taxes won’t affect your lifestyle, they could have a big impact on your survivors. You might think that your estate won’t be big enough to be taxed – after all, the federal estate tax only applies to estates larger than $5.45 million (or $10.9 million for married couples) in 2016.4 But at the state level, the exemptions can be much lower than the federal amount, so it is possible that you could not owe federal estate tax and still owe estate tax at the state level.
In any case, given the variety of taxes and the different levels of taxation that exist at the state level, you will want to do your homework before uprooting your life. And that leads us to another issue: residency.
Establishing residency: more than a mailbox.
Establishing residency in a new state isn’t as simple as spending the majority of the year there. In recent years, states – especially ones, such as Illinois, that are facing budget crunches – have become more aggressive questioning taxpayers’ residency claims. So if you are thinking of maintaining homes in multiple states, be prepared to take some proactive steps to establish your residency in the low-tax state.
Things you can do to help show that you have set down roots in the new state and support your residency claim include:
- Transferring your bank accounts to a bank in the new state
- Registering to vote in the new state
- Registering your car in the new state
- Getting a new driver’s license in the new state
- Changing your address for credit cards, insurance, and other accounts
In short, you may need to make a case for why you should be treated as a resident of the new state rather than the old state. So you should take action to proactively build that case.
Looking beyond taxes.
Clearly taxes are a very important consideration when it comes to your retirement, but they are just one piece of the puzzle. In the investing world, an important adage is “don’t let the tax tail wag the dog.” This advice applies to where you live in retirement, as well. Think about your overall quality of life and financial picture, and make the decision based on what makes the most sense for you and your family.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Leelyn Smith LLC, a registered investment advisor and separate entity from LPL Financial. Tax related services offered through Leelyn Smith Tax, LLC, a separate legal entity not affiliated with LPL Financial. LPL Financial does not offer tax advice or related services.
1 Tax Foundation. “State Individual Income Tax Rates and Brackets for 2016.” February 8, 2016.
2 Tax Foundation.
3 Kiplinger Personal Finance. “Which States Tax Social Security Benefits.” November 2015.
4 Internal Revenue Service. “Estate Tax.” May 4, 2016.