How Will State and Local Taxes Affect Your Retirement?

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When deciding where to retire, many individuals and couples put lifestyle factors front and center in the decision-making process. Should they stick it out in chilly northern climes with their kids and the rest of the extended clan, or does the lure of being able to golf and sit on the beach year-round outweigh those familial considerations?

Weighing such quality-of-life factors is, of course, crucial to a successful retirement. But most people getting ready to retire also, necessarily, add financial factors to their decision-making matrixes. Geographic location has a huge impact on how much you pay for housing, of course, as well as food, utilities, and other basics; where you reside is also a key determining factor in how much you pay for health-care and long-term care costs. (Morningstar contributor Mark Miller discussed the extent to which health-care costs vary by locale in this article.)

Taxes are another retirement cost that varies greatly by location. The average U.S. taxpayer contributed nearly 10% of his or her income to state and local coffers in 2010, according to the Tax Foundation. But that average concealed a fairly broad gradation in tax-related outlays. Residents of Alaska shouldered the smallest tax burden as a percentage of income per capita in 2010; Tennessee and South Dakota residents, too, enjoyed fairly modest state and local tax levies. Meanwhile, residents of New Jersey, New York, Connecticut, Wisconsin, and California shouldered per capita tax burdens of more than 11%. New York State won the unenviable title of highest-tax state in 2010, with a per capita tax burden of 12.8%, nearly 6 percentage points less than Alaska's.

Of course, even if your state's tax burden is on the high side, the variation of high- to low-tax states might not be enough to affect your decision-making. But locales with high tax costs often feature a steeper cost of living in general--more expensive housing as well as higher charges for food, gas, and other essentials. If you live in a state that's costly overall, you can generally add high state taxes to your expected outlay. On the flip side, if you're willing to relocate to a state that is cheaper to live in, lower state and local taxes may well be part of the package.

Even if you'd like to stay put in a high-cost state, there are steps you can take to control your costs. Below, I'll survey some of the largest categories of state and local taxes--income, sales, property, and estate/inheritance--and suggest some workarounds for folks who have decided to stay put in a high-cost locale.

Income Taxes
Forty-three states impose income tax at the state level, often basing the tax you owe on line items on your federal tax return, such as modified adjusted gross income. The tax may be flat, as with Indiana's 3.4% across-the-board rate, or graduate upward based on income. Seven states, including Florida and Texas, have no state income tax. Yet before you put these no-tax states on your short list of potential retirement destinations, bear in mind that states may make up for low or no taxes in one area with higher taxes elsewhere. Although Washington has zero income tax, for example, combined state and local sales tax can run over 9%.

States take different approaches to taxing retirement income, too. (By clicking on this map, you can drill into some of the specifics.) Most states exempt Social Security income from state tax; pension benefits may also be partially or entirely tax-free in certain states. The taxation of other types of retirement income varies widely by state. Despite high sales tax rates, for example, Illinois excludes many types of retirement income from taxation, including 401(k) and IRA distributions.

The Stay-Put Workaround: Because state income taxes are often keyed off of items on your federal return, many of the usual tax-lowering mechanisms, including charitable donations and managing your portfolio for tax efficiency, will translate into state-tax savings, too. In addition, people who live in a high-tax state that doesn't tax municipal income from instate bonds have a strong incentive to park taxable money for short- and intermediate-term income needs in a municipal-bond fund geared toward their home state. (Not surprisingly, there's a proliferation of municipal funds geared toward residents of notably high-tax states such as New York and California.) Retirees who have the luxury of owning two homes--one in a state with high income tax and another with a low levy or none, such as Florida--should also take a hard look at where they claim residency and, in turn, file their tax returns. Assuming they fulfill the residency requirements of the low-tax state, they can realize substantial savings by becoming a permanent resident of that low-cost state.

Sales Taxes
Sales taxes often work in tandem with income taxes: A state with a higher income tax rate, such as Oregon, may have zero sales tax, whereas a state with high sales taxes may have a relatively low income tax rate. In addition to state tax rates, municipalities are also able to levy sales tax at the local level, meaning that you can still end up paying a high combined sales tax rate in a state with a low state sales tax rate. (Louisiana is a good example; the state rate is low, but high sales taxes at the local level bring the combined sales tax rate to a high level.)

To further complicate matters, states and municipalities vary in how they tax various items, with essentials such as groceries often taxed at a more favorable rate than discretionary items. Generally speaking, sales taxes will tend to penalize lower-income seniors more than higher-income retirees because the former group necessarily must spend more of their income than the latter. Thus, lower-income seniors may benefit more from relocating to a state with low sales taxes than will higher-income retirees, though that benefit may be mitigated by the fact that groceries and other basics are typically taxed at a lower level than discretionary items.

The Stay-Put Workaround: Retirees who live in a high-cost locale but would like to reduce their sales tax outlays have a couple of options. Depending on where you live, shopping in a municipality with lower tax rates might be worth your while. And if it's your local sales tax, rather than state sales tax, that's responsible for above-average sales taxes where you live, you may not even have to cross the state line. (Just be sure to gang up your shopping trips so gas costs don't erode your savings.) Buying items online has long been another way to skirt sales tax, but bear a couple of things in mind before considering this a safety valve. First, shoppers are in fact currently legally obligated to pay state sales tax, though few currently comply with the law. Second, Congress has been considering legislation that would force Internet retailers to levy sales tax on online purchases; the bill, called the Marketplace Fairness Act, reportedly enjoys widespread bipartisan support.

Property Taxes
Even if you own your home outright, property taxes may make living there unaffordable. Yet the range in property tax is broad from one geographic location to the next. Of course, home value plays a role in determining property taxes, with owners of higher-priced homes naturally paying more in taxes than owners of lower-priced homes. But property taxes as a percentage of home value also vary significantly by geography; in other words, someone with a $250,000 home may be paying a higher percentage of his or her home value in property taxes than someone with a $2.5 million home. The Northeast--especially the wealthy counties around New York City--features some of the highest property taxes in the United States--both in absolute terms and as a percentage of home value. Residents in the southern U.S., meanwhile--especially states like Louisiana and Alabama--will generally pay lower real estate taxes.

The Stay-Put Workaround: If your property taxes on your existing home have gone through the roof, you have a few different options. Downsizing could reduce your tax bill, of course, and renting instead of owning can help you avoid property taxes altogether. (Bear in mind that even renters are apt to pay property taxes indirectly through their rents, so if the overall trend in tax rates is up in your community, your landlord is likely to pass those costs through to you.) If you'd like to stay in your current home, your local assessor's office will provide a few options for bringing your taxes down. You could file an official appeal if you think your home's assessed value is higher than that of similar properties. At the same time, you could also investigate programs such as homestead exemptions, senior exemptions, longtime homeowners exemptions, and senior freezes for those with low incomes. This article takes a closer look at mechanisms for lowering your property tax bill.

Estate Taxes
With the federal estate tax exclusion amount at more than $5 million currently, some retirees might assume they're in the clear from an estate tax standpoint because their assets are well under that threshold. Never assume. Twenty-one states and the District of Columbia levy some form of tax upon death, either estate tax or inheritance tax, for estates valued over a certain level. (An estate tax is a tax levied on the estate itself, assuming its value exceeds a certain threshold, whereas an inheritance tax is imposed upon the person who inherits the assets.)

In some states that levy an estate tax, the exclusion amount is just the same as it is at the federal level, $5.25 million; if you're not in that rarefied ballpark, no worries. But in other states, the estate tax is imposed at a much more modest asset level. New Jersey has an estate tax exclusion amount of just $675,000, for example, the lowest of any state. Rhode Island's exclusion amount is just under $1 million, while several other states, including Massachusetts, Minnesota, New York, and Oregon, levy estate taxes on amounts of more than $1 million. With exclusion amounts at those levels, it's easy to see how someone with a fairly modest portfolio plus a home could see their assets affected by state estate taxes.

The Stay-Put Workaround: With the federal estate tax exclusion amount as high as it is, as well as a portability provision that allows surviving spouses to use the unused exclusion amount of the first spouse to die, credit-shelter trusts (sometimes called bypass trusts) may seem like a vestige of a bygone era. These trusts allow married couples to take maximum advantage of each partner's exclusion amount. However, if you live in a state with an estate tax that kicks in at a fairly low level, setting up such trusts may in fact be beneficial. Charitable gifts and gifting to loved ones during your lifetime--up to the annual amount that's excluded from gift tax considerations--is, of course, another way to reduce your estate's susceptibility to estate taxes, both state and federal.

 

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