Taxes, as many know, are among the biggest expenses people face in retirement. So it should come as no surprise that many retirees and would-be retirees ponder the thought of moving to a tax-friendly state.
But which are the most tax-friendly states? Well, it’s not an easy question to answer according to Kathleen Thies, a state tax analyst with CCH, a Wolters Kluwer business. States that have high personal income-tax rates might have low property tax rates and states with low personal income-tax rates might have high property tax rates.
And so the end game for those looking to find the most tax-friendly state is to review all their sources of income in retirement including earned income, Social Security, pensions, and unearned income; all the different types of taxes they might face in retirement including personal income, sales, property and the like; and their overall tax burden, Thies said in an interview.
For instance, those who depend less on Social Security and more on earned income in retirement might consider moving to a state with lower or no income-tax rates. Others who rely heavily on Social Security, by contrast, might consider moving to a state that doesn’t tax such benefits.
“People think they will move to Florida, or Texas, or Nevada and they won’t have any income tax,” she said. “But you have to remember that every state is a business and they need to create revenue. So if they aren’t doing it through income tax they will get it some other way, such as sales or property taxes.”
To be fair, taxpayers who contemplate retiring to one state or another or who contemplate retiring in place also have to calculate whether deducting certain taxes—income, sales, and property—on their federal tax return will make a difference on their overall tax burden.
“It’s so difficult to say which is the most tax friendly state because there are so many variables for each individual,” said Thies. “Overall, it’s a case-by-case basis.”
So what then are the key taxes seniors should assess when evaluating the financial implications of moving or staying put? According to Thies and CCH, they include the following:
State taxes on retirement benefits
Seven states do not tax individual income—retirement or otherwise, CCH said in a release. Those include Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. Two other states—New Hampshire and Tennessee—impose income taxes only on dividends and interest (5% for New Hampshire and 6% for Tennessee for 2012 and remain the same in 2013), CCH said.
Click here or on the image above to see a full PDF of how states tax various sources of retirement income.
In the other 41 states and the District of Columbia, CCH said, tax treatment of retirement benefits varies widely. For example, some states exempt all pension income or all Social Security income. Other states provide only partial exemption and some tax all retirement income.
States exempting pension income entirely are Pennsylvania and Mississippi. States exempting a portion of pension income include: Arkansas, Colorado, Delaware and New York. States generally taxing pension income include: Arizona, California, Minnesota and Rhode Island. (See pdf chart for additional details.)
“Looking at states that don’t tax individual income tax is good place to start when thinking about which state to retire,” said Thies. “There are reasons why so many people move to Florida. Much of it is the weather but some of it is the favorable tax treatment.”
Thies also said taxpayers should keep an eye on the funded status of their state and city pension plans. Those with underfunded pension plans, for instance might be forced in the future to raises taxes or reduce government services, or both.
The Pew Charitable Trusts has two reports on the health of pensions for states and cities. For instance, Connecticut, Illinois, Kentucky, and Rhode Island were the worst among the states, with pensions funded under 55% in 2010, according to one report. And in four cities—Charleston; Omaha; Portland, Oregon; and Providence, Rhode Island—pension systems were more poorly funded than those in Illinois, which at 51% was the lowest-funded state, according to another Pew report.
Read A Widening Gap in Cities.
Read The Widening Gap Update: States are $1.38 Trillion Short in Funding Retirement Systems. Read those reports to learn which other states and cities are most at risk of raising taxes, cutting services, or both.
In general, Thies said, there’s been so much uncertainty at the federal and state levels that the time to drill down on which might be the most tax-friendly state for you is when you’re ready to sell your home. “We generally don’t hear about people picking up and move just for the favorable tax treatment,” she said. Instead, other factors play a role including whether a person has friends and family in a new locale.
States announcing changes to income tax for retirement plans
A handful of states announced changes to income tax for retirement plans in 2012. According to CCH, those include:
Georgia: The personal income retirement exclusion amount has been capped at $65,000 for taxpayers 65 years of age or older and $35,000 for certain taxpayers between ages 62 and 65—for tax years beginning on or after Jan. 1, 2012.
Kentucky: At the end of 2012, The Kentucky Blue Ribbon Commission on Tax Reform proposed a reduction in the individual income tax pension exclusion from $41,110 to $30,000 and implemented a dollar-for-dollar phase out for income over $30,000.
Maine: In 2012, a law was enacted to limit the income tax deduction for certain retirement benefits for tax years beginning after 2013. This raises the deduction from $6,000 to $10,000 (reduced by the total amount of the taxpayer’s Social Security benefits and Federal Railroad Retirement benefits). The deduction is also expanded to include all federally taxable pension income, annuity income and individual retirement account (IRA) distributions, except pickup contributions for which a deduction has been allowed.
Michigan: The deduction for pension benefits for senior citizens is curtailed based on the taxpayer’s birth year and household resources. Currently, this deduction is limited by a dollar amount, but no other limitation applies. Specifically, for persons born before 1946, the deduction for pension benefits is unchanged (see pdf chart). However, for persons born in 1946 through 1952, the deduction for pension benefits is limited to $20,000 for a single return and $40,000 for a joint return. And after that person reaches age 67, the pension benefits deduction is no longer applicable, but the taxpayer is eligible for a deduction of $20,000 for a single return and $40,000 for a joint return against all types of income. A third set of options is available for taxpayers born after 1952, when they reach age 67.
Screening states in or out based on how they tax income is a good place to start, but Thies also noted that much could change in how states raise revenue in the future. For instance, she said some states are starting to lower personal income-tax rates this year, but increase sales tax rates. Massachusetts and Nebraska are two such states that have proposed lowering personal income-tax rates and raising sales tax rates.
Decreasing personal income-tax rates and increasing sales tax rates is a way to relieve the burden on the income tax side and put more money in the pockets of consumer in hopes of stimulating the economy. “It’s a way of collecting taxes tax on the back end,” Thies said. “I expect that this will be a trend that will continue and it will be interest to see how much traction it will get.”
Retirees will certainly benefit in states that follow this trend. Instead of being taxed up front on their personal income, retirees can choose when to be taxed and by how much. “People can regulate their spending” said Thies.
Fourteen states tax Social Security
While some states tax pension benefits, only 14 states impose tax on Social Security income, according to CCH. Those include Colorado, Connecticut, Iowa, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont and West Virginia. These states either tax Social Security income to the same extent that the federal government does or provide breaks for Social Security income, often for lower-income individuals, CCH said in its release.
Retirees can rule in or out certain states to which to retire based on whether and how they tax Social Security. After all, Social Security represents on average 36.5% of all types of income for all retirees and 17.9% for those retirees in the upper income quintile. But they should review that list annually, Thies said.
That’s because many states are moving away from taxing Social Security. “It’s something to look out for,” she said. “But every year it seems like we get one more state that does away with taxing Social Security to the same extent that the federal government does. What happens on the pension income side, however, is another story.”
Thies noted that many would-be retirees and retirees often think they are leaving a high-tax state for what they think is a low-tax state only to find out that they were wrong. “People tend to think the grass is always greener on the other side,” she said. But if you are a high-end wage earner with lots of unearned income you might want to move to a state that also taxes dividends and interest.
Still, one shouldn’t let the tax tail wag the retirement state dog. Retirees and would-be retirees should contemplate nontax factors as well before deciding where to live, Thies said. “You also need to think about family responsibilities and care of elder parents and relatives,” she said. “There are lots of things to consider, taxes being just one of them.”
State income-tax rates
In addition to state taxes on retirement benefits, other taxes that seniors should consider when evaluating the financial implications of where they may to retire include state income-tax rates, CCH said.
For example, income-tax rates also can have a significant financial impact on retirees in determining where they want to live and can vary widely across the country, CCH said.
“As some retirees will face higher federal income taxes, they may look more closely at states with lower or no income-tax rates as one way to help offset their overall tax obligation,” said Thies.
While seven states have no income tax and two tax only interest and dividend income, several have a relatively low income-tax rate across all income levels. For example, the highest marginal income-tax rates in Arizona, New Mexico and North Dakota are below 5%.
Some states have a relatively low flat tax regardless of income, with the three lowest: Indiana (3.4%), North Dakota (3.99%) and Pennsylvania (3.07%) for 2013.
State and local sales taxes
Forty-five states and the District of Columbia impose a state sales and use tax (only Alaska, Delaware, Montana, New Hampshire and Oregon do not impose a state sales and use tax), CCH said.
States with a state sales tax rate of 7% include Rhode Island, Indiana, Mississippi, New Jersey and Tennessee, CCH said. California has a state sales tax rate of 7.5%.
According to CCH, local sales and use taxes, imposed by cities, counties and other special taxing jurisdictions, such as fire protection and library districts, also can add significantly to the rate. Given that, you ought to look at the combined state and local sales tax when looking for a state to call home in retirement.
For instance, Tennessee (9.44%), Arizona (9.16%), Louisiana 8.87%), Washington (8.86%) and Oklahoma (8.67%) have the highest combined state and local sales taxes according to a new report from the Tax Foundation.
And the five states with the lowest combined state/local rates greater than zero are Alaska, Hawaii, Maine, Virginia and Wyoming, according to the Tax Foundation.
And five states have no statewide sales tax, according to the Tax Foundation: Alaska, Delaware, Montana, New Hampshire and Oregon. Of these, Alaska and Montana allow cities and towns to levy local sales taxes.
Read State and Local Sales Tax Rates in 2013.
State and local property taxes
While property values have declined over recent years in many areas, that has not necessarily been the case for property taxes, CCH said. “However, many states and some local jurisdictions offer senior citizen homeowners some form of property tax exemption, credit, abatement, tax deferral, refund or other benefits,” CCH said in its release. “These tax breaks also are available to renters in some jurisdictions. The benefits typically have qualifying restrictions that include age and income of the beneficiary.”
For the record, in 2010, the residents of New York, New Jersey, and Connecticut paid the highest state-local tax burdens in the nation, according to the Tax Foundation. These are the only three states where resident taxpayers forego over 12% of income in state and local taxes.
Residents of Alaska, who have consistently been the least taxed state for nearly three decades, again paid the lowest percentage of income in 2010 at just 7%, the Tax Foundation said in its report. The next lowest-taxed states were South Dakota, Tennessee, and Louisiana.
Read Annual State-Local Tax Burden Ranking (2010)—New York Citizens Pay the Most, Alaska the Least.
Thies said property taxes represent a large and growing portion of a retiree’s expenses, especially if they own a large home. So retirees often must face the decision of living in place, downsizing but relocating to a lower property tax rate municipality not far from where they might already live, or relocating to a municipality with low property tax rates. “We do that property tax rates go up every year,” said Thies. Yes, many retirees want to stay in familiar surroundings but they really need to consider whether they need to live in the same house as when they were raising a family. “Property taxes can really affect retirees living on a fixed income,” Thies said. “It’s a difficult to decision to make because many people are tied to their homes emotionally. But it may cost you a lot more than you realize.”
To be sure, this is a classic between-a-rock-and-hard place issue. If a retiree ages in place, their property taxes will in fact rise. But if they move, even to a low property tax municipality, they might find that their overall tax burden is unchanged or worse, higher.
State estate taxes
Estate taxes also can influence where seniors want to retire. Rules vary from state to state as well as from federal estate tax laws. For example, 18 states impose a tax on estates valued below the $5.25 million federal threshold for 2013 ($5.12 million for 2012); only Delaware, Hawaii and North Carolina use the federal exclusionary amount. However, three states have no estate tax at all—Kansas, Oklahoma and Arizona.
Thies said she doesn’t see state estate taxes being a major factor for average Americans deciding where to retire. “People who have estate tax issues are at the top end,” she said. “They are in a different echelon.”
Indeed. “The American Taxpayer Relief Act of 2012 brings more clarity on the federal level that only estates above the $5 million mark indexed for inflation will be subject to the federal estate tax,” James Walschlager, an estate planning analyst at CCH said in a release. “However, the threshold in some states can be below $1 million for state estate taxes, which can impose additional planning challenges.”
Most states follow federal estate tax and would have seen a windfall to state coffers had the estate tax sunset to the pre-Bush era maximum 55% tax rate on estates over $1 million. However, even though that didn’t happen, some states have decoupled from federal estate tax law over the past several years as a way of holding on to tax revenues. In many of these states, residents can expect to pay taxes on estates well below the $5.25 million federal threshold for 2013 ($5.12 million for 2012).
“States that have stayed with the federal estate tax law, assuming it would be returning to the lower exclusion amounts, may now reconsider,” Walschlager said.
According to CCH’s release, states currently following the pre-Bush era estate tax provisions include: Delaware, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, North Carolina, Rhode Island and Vermont as well as the District of Columbia.
Only Delaware, Hawaii and North Carolina follow the federal estate tax exclusion threshold. A few other states have enacted their own estate tax law separate from federal law. These include Connecticut, Oregon and Washington, as well as effective Jan. 1, 2013, Maine. Ohio repealed its stand-alone estate tax and has now recoupled with the federal estate tax law effective as of 2013.
Four states and the District of Columbia also allow domestic partners to file joint tax returns, CCH said in its release. This allows the partners to be recognized under their state’s estate tax laws and thereby enables the surviving spouse to avoid paying any taxes on the decedent’s estate.
Three states have no estate tax at all. These are Kansas, Oklahoma and Arizona, CCH said.
In addition to estate taxes, eight states also collect an inheritance tax, CCH said. “This is a tax on the portion of an estate received by an individual. It is different from an estate tax, which taxes an entire estate before it is distributed to individual parties,” CCH said. “These states are Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania and Tennessee ‒ which is phasing out its inheritance tax in 2015. Assets transferred to a spouse are exempt from the inheritance tax, and some states exempt assets transferred to children and close relatives.”
For more estate tax issues, read CCH Says Latest Tax Law Brings Some Certainty Back to Estate Tax Planning, But Decisions Remain.
So, really, there are no tax-friendly states per se—but there are plenty of states that might be friendly for you, if you’re willing to crunch the numbers.
Robert Powell is a featured writer on the MarketWatch Retirement blog, a Research Fellow at the California Institute of Finance, and a Featured Contributor here on the CIF blog.