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Investing Specialists

How State and Local Taxes Affect Your Retirement Plan

With state and local budgets under pressure because of the coronavirus, taxes from these entities may become a front-burner issue if they're not already.

Editor's note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

State and local finances were under pressure in many geographic locales even before the pandemic, with pension and healthcare expenses for retired workers a particularly big overhang. But coronavirus-related economic weakness has exacerbated those woes

As economic activity has declined, so have tax receipts. At the same time, states and municipalities are having to step up healthcare, unemployment assistance, and other services to address the crisis.

Those pressures are likely to force cash-strapped state and local governments to slash spending on other services and infrastructure even more, and they could also force higher taxes down the line. In contrast with the federal government, state and local governments can't run deficits.

Unfortunately, some of the states and municipalities that were in the worst shape coming into the current crisis--and had the highest tax rates pre-pandemic--have borne the brunt of the pandemic and its related economic ills. That list includes New York, New Jersey, and Illinois. That suggests that some state and local governments may need to resort to a combination of budget cuts and tax hikes to balance their books.

And even before the pandemic, the role of state and local taxes had already been grabbing an increased role in the retirement-planning discussion, as older adults in high-tax states balanced the cost savings of relocating alongside other factors, such as proximity to family and friends. Florida, Arizona, South Carolina, and North Carolina have all seen large influxes of retirees in recent years. Of course, that owes in part to their warmer weather and abundant sunshine, but lower taxes and a lower overall cost of living have no doubt played a role in retirees' decision to relocate, too.

Ultimately, the decision about where to live in retirement is about much more than money and weather. It also involves family connections and cultural preferences, among other factors. But disparities in cost of living among states and municipalities--including taxes--mean that finances are likely to take up an even bigger share of the discussion about where to live in retirement.

At the same time, it can be tricky to make apples-to-apples comparisons among different geographies. Not only do states vary widely in terms of how they tax retirees, but your taxation also depends on your specific situation: your sources of retirement income, whether you're a property owner, and the amount of assets you expect to leave to loved ones as part of your estate. For example, Illinois has some of the highest property and sales tax rates in the United States, but it doesn't tax retirement income or Social Security benefits and has an estate-tax exclusion of $4 million. Thus, for someone who doesn't own property, doesn't buy much, derives most of his or her income from tax-sheltered retirement accounts and Social Security, and doesn't expect to leave an estate of more than $4 million, the state isn't a terrible place to retire. (The weather is another story!)

Let's take a look at some of the largest categories of state and local taxes--income, sales, property, and estate/inheritance--and discuss how to get your arms around them. And remember to watch this space, as states and municipalities change their tax regimes to accommodate changes in their budgets. Tax Foundation supplies excellent ongoing data and analysis on various tax matters, including a comparison of various states' tax systems

Income Tax
All but seven states currently levy income taxes; those seven are Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Another two, New Hampshire and Tennessee, don't tax wages but they do tax dividends and income. Tennessee will phase out its tax on interest and dividend income in 2021, though, while New Hampshire expects to fully phase out its tax on interest and dividends by 2025.

Among most states that levy tax on income, tax rates are graduated (or progressive), meaning that people with higher levels of income pay tax at a higher rate. But nine states levy a single tax rate across all income levels.

Yet before you put the no- or low-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 10% in some cities, including Seattle.

Also bear in mind that the taxation of retirement income varies widely by state, with many states reducing or eliminating levies for income that counts as "retirement income"--pension income, retirement-plan withdrawals, and Social Security income. While the seven states mentioned above don't tax income of any kind, an additional four--Illinois, Pennsylvania, Mississippi, and Hawaii--don't tax retirement income. Most states exempt Social Security income, or a portion of it, from state tax. Pension benefits may also be partially or entirely tax-free in certain states. Those variations make it important to think through the specific types of retirement income you'll rely on when determining how tax-friendly your state is.

Sales Tax
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, like Washington, may have a relatively low income tax rate or no income tax at all.

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. As of 2019, Tennessee, Louisiana, Arkansas, Washington, and Alabama levied the highest combined state and local taxes of any state, according to Tax Foundation.

To further complicate matters, states and municipalities vary in how they tax various items, with essentials such as groceries and prescriptions often taxed at a more favorable rate than discretionary items. But 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.

Property Tax
Property taxes are one of the largest line items in the budget for retiree homeowners, and the range in property tax is broad from one geographic location to the next. That helps explain why relocating to an area with lower property taxes is often near the top of the list for retirees who would like to cut their spending.

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 U.S.--both in absolute terms and as a percentage of home value. Ditto for Illinois and especially the Chicago suburbs. Residents in the southern and western U.S., meanwhile, will generally pay lower real estate taxes. As of 2018, residents of Hawaii, Alabama, Colorado, and Louisiana paid real estate taxes at the lowest average effective rate of any state's residents, according to WalletHub

Estate/Inheritance Tax
I've long emphasized the importance of having an estate plan, even for people whose assets don't put them at the rarefied level for estates to be subject to federal estate tax--$11.58 million per individual in 2020.

One reason is that states that levy estate taxes often exclude a much smaller amount of assets from state estate or inheritance taxes than is excludable from federal estate tax. What's the difference between an estate and an inheritance tax? The former is 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. (The amount of inheritance tax is typically based on the inheritor's relationship with the deceased, with immediate family members typically paying the lowest rate.)

Despite the overall trend toward higher state and local taxes in many areas, the share of states that impose estate and inheritance taxes is shrinking--it was 21 in 2013 and now just 12 states and the District of Columbia do. But as noted above, there can be a big disconnect between the amount of an estate that's excludable from federal and state taxes. In Massachusetts and Oregon, for example, estates of more than $1 million are subject to the state estate tax, even though more than $11 million is excludable from federal income taxes.

If you live in a state with an estate tax that kicks in at a fairly low level, setting trusts may 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 another way to reduce your estate's susceptibility to estate taxes, both state and federal.