Today I’m talking about state taxes (in retirement!).
Specifically, I’m sharing three important facts that often fly under the radar.
I’m also clearing up common misconceptions and sharing real-life examples.
If you’re ready to learn how state income taxes will impact your bottom line in retirement, this episode is for you.
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3 Important Facts About State Taxes in Retirement
Taylor Schulte: Mr. and Mrs. Jones are 70 years old and retired.
They have $48,000 in Social Security income.
$18,000 in pension income.
And $24,000 in earned income.
With $90,000 in total gross income each year, would you believe me if I told you that the Joneses could have a 0% income tax rate in 20 states including a high-tax state like New Jersey? How about a 0.3% effective tax rate in California and 0.4% in New York?
Welcome to the Stay Wealthy podcast, I’m your host, Taylor Schulte, and today I’m going to explain how this is possible.
To help, I’m going to be sharing 3 important facts about state income taxes in retirement.
And really quick before we dive in, just a quick disclaimer that this is being published in the fall of 2022 and I’m using currently known state tax rates and policies for the different examples today (some of which are from 2021). Taxes and tax laws can change quickly, so just know that you might come to a different conclusion when crunching your own numbers depending on when you listen to this episode.
For all the links and resources mentioned today, head over to youstaywealthy.com/172.
For those who don’t know, my family and I live in San Diego, CA. In fact, my wife and I have lived here our entire lives.
And being a native Californian, you can only imagine how many times I’ve fielded comments and questions about taxes in this state. California not only has the highest income tax rate in the U.S. at 13.3%, but we also have the highest sales tax rate at 7.25%
Like me, listeners in states like Hawaii, New Jersey, and New York (just to name a few) are also probably reminded more than they would like about living in a “high tax state.”
But, like most things in life, taxes aren’t so black and white. Contrary to popular belief, many of these “high tax states” are actually quite friendly to retirees. And many of the states who have earned the reputation of being “tax-friendly” often catch people off guard with hidden taxes and fees that end up being the opposite of friendly.
My guiding philosophy in financial planning (and in life) is to focus on the things you can control. And while we can’t necessarily control the tax rates, we can control where we live and how we manage our income in retirement to ensure we don’t overpay the IRS.
Now, I’m not suggesting that you choose to live in the state that provides you with the lowest tax bill, there are, of course, many other factors to take into consideration. But, knowledge is power and looking past the broad-based statements, assumptions, and misconceptions, and taking the time to understand exactly how state taxes are impacting (or will impact) your bottom line in retirement, will help you make informed decisions with your money.
Better understanding state taxes could also lead you to learn that, contrary to what you previously assumed, relocating to a place like Sunny San Diego in retirement isn’t actually a bad financial decision. In fact, depending on your income sources, marital status, age, and a few other factors, it might be a better financial decision than other options you were considering.
So, to help get you, today I’m going to share 3 important facts about state taxes in retirement. I’m also going to breakdown the example I shared at the top of the show – that couple with $90,000 of gross income and how they’re able to achieve a 0% state income tax rate in 20 states when, on the surface, there are only 9 states that advertise zero state taxes.
This is a topic I’ve wanted to cover for a while now and I have to give a big thank you to Ben Henry-Moreland at Kitces.com for recently publishing one of the most comprehensive guides on this topic. So, if you leave this episode wanting to learn more about navigating state taxes in retirement, I’ll be linking to his article in the show notes which can again be found by going to youstaywealthy.com/172.
The first important fact to share is that there are 32 states (plus the District of Columbia) that exclude 100% of Social Security income from taxation. 32 states that don’t tax social security. If we add the 9 states that we already know don’t have state income tax on any form of income, we end up with 42 total territories in the U.S. where Social Security income – a major source of income for most retirees – is not taxed.
One thing to highlight here is that the exclusion of Social Security income can also help to reduce the taxes you might pay on other income that is taxable.
For example, let’s say that I’m retired, single, and I have two sources of income: $40,000 per year from Social Security and $60,000 per year from my pension. Let’s also say that I’m considering moving to either Vermont or California. Just like California, Vermont has a progressive tax structure, so the more taxable income I report in a given year, the higher of a % tax rate I pay.
However, unlike California, Vermont does tax Social Security income.
So, going back to my example where I have $40,000 of Social Security income and $60,000 of pension income. In this example, in the state of Vermont, my taxable income would be $94,000. (Note, it’s $94,000 because only 85% of social security income is taxed just like federal tax laws.)
So, in Vermont, with the taxation of social security, my taxable income would be $94,000, thrusting me into a higher tax bracket.
In California, on the other hand, Social Security is excluded, so I would only have taxable income of $60,000 – the income from my pension.
Using IRScalculators.com, and ignoring any other deductions, exemptions, or credits, my Californa state tax bill would be about $2,220. In Vermont? It would be almost double, at an estimated $4,200.
Now, If I didn’t have Social Security income, and I just had $60k of pension income to live off of, California would be the more expensive state for me to live in. In other words, stacking Social Security income on top of my pension, would not only result in more income to me but it would also lead me to have a lower tax bill in California than in Vermont.
Again, this is a very plain-vanilla high-level calculation that doesn’t take any other exclusions or credits into consideration and therefore your personal situation may lead to different results. The bottom line is that the exclusion of Social Security income from state taxation helps to reduce taxes on other forms of taxable income in states with progressive tax structures.
So, to recap, there are 41 total states (plus the District of Columbia) that don’t tax Social Security income. And that exemption, in some cases, can also keep taxes low on other income you might have, opening the door to consider living in a state that is often perceived as having high taxes.
The second important fact to share with you today is that there are 3 states that exclude Social Security income, pension income, AND income from qualified retirement plans. Those three states are Mississippi, Illinois, and Pennsylvania. And those states are not part of the 9 states that are already known to have 0% tax rates.
So, if your income only consists of Social Security, pension, and/or qualified retirement plan distributions, you would have 12 total states to choose from that won’t tax any of your income. In addition to the three I just named, those states would be Alaska, Florida, South Dakota, Tennessee, Texas, Washington, Wyoming, and New Hampshire.
Perhaps you don’t have any desire to live in one of those 12 states. No problem – there are 21 other states that exclude “some” retirement and pension income. To see those states and the exact exclusion rules, check out Ben’s article at Kitces.com that I’ll be linking to in the show notes.
To recap, there are 3 states that exclude Social Security income, pension income, AND income from qualified retirement plans. Add the other 9 states with 0% tax rates across the board and you have a total of 12 states to choose from that would result in zero state taxes.
The third important fact to share with you today is that there are 29 states across the country that offer “age-based” tax benefits for people over age 65 (i.e., retirees). These benefits come in all different shapes and sizes and vary by state, but the good news is that they apply to all forms of income and, in many cases, are on top of other tax benefits you might already be receiving.
So, in the right state, at the right age, with the right type and amount of retirement income, you could find yourself in a situation where adding additional income from part-time work or stock dividends or interest on cash savings, would result in no additional state income tax.
Which leads us nicely into the example I shared at the top of the show.
Once again, Mr. and Mrs. Jones are 70 years old.
They have $48,000 in Social Security income.
$18,000 in pension income.
And $24,000 in earned income.
While there are only 9 states that advertise 0% state income tax, Mr. and Mrs. Jones, after listening to today's podcast episode, learn that there are actually 20 total states that would result in 0% state income tax given their current situation.
One of those states is New Jersey, which has the 4th highest tax rate in the country. But, perhaps even more surprising, is that with $90,000 of gross income – 25% of which is earned income – they would only have an effective tax rate of only 0.3% in the state of California, the state with the single highest tax rate.
Here is how this breaks down:
As we now know, Social Security income is not taxed in CA so we can remove that from the equation.
The $24,000 of earned income plus $18,000 of pension income equals $42,000. With that $42,000 of gross income, we would then apply their standard deduction of $9,606, arriving at a taxable income of $32,394 and a projected tax bill of $760.
A $760 tax bill doesn’t even sound bad. But we’re not done yet.
Because they’re over age 65, we would subtract their personal exemption credits of $516, arriving at a final tax bill of $244 (using 2021 tax policies).
Finally, if we divide $244 by their total gross income of $90,000, we would find out that their effective tax rate is a mere 0.3% in the state with the highest tax rates in the country.
Maybe California isn’t for you. No problem. In addition to California, there are a total of 34 other states to choose from that would also result in an estimated effective tax rate of less than 1%.
In case you’re wondering, the most expensive state for Mr. and Mrs. Jones would be Utah, with an estimated effective tax rate of 3.6%. After Utah, Oregon, Montana, Missouri, and Massachusetts would be the next group of states with the highest effective tax rate for them…hovering around 2% or a little higher.
Now, as mentioned at the top of the show, your effective state tax rate is just one of many factors to take into consideration when thinking about where you might live in retirement. Sure, Mr. and Mrs. Jones could have an effective tax rate of 0.3% in California, but according to Bankrate.com, the cost of living is 36% higher than Utah, which was the state we estimated to produce the highest state tax bill for them. So, lower tax bill in California, but a much higher cost of living that you’ll likely want to factor in.
And this can work the other way around, too. Some of the states that, on the surface, appear to be tax-friendly due to low or no state income taxes, have other taxes and fees that can catch people off guard. In some cases, it’s not only additional fees but also increased risk. For example, in Florida, a state with 0% income tax rates, 2 out of every 3 homes are uninsured or underinsured due to insurance companies are going under or no longer writing new policies.
On top of low or no insurance, homeowners have had two special assessments this year by the Florida Office of Insurance Regulation to help cover the costs associated with insurance companies going out of business. So, lower taxes, but heightened risk for homeowners and increased insurance costs.
And then, of course, there are dozens of other factors that have nothing to do with money or risk and everything to do with your personal preferences. As a professional in the working world earning a healthy income, California is far from being tax-friendly to me. In addition to taxes, the cost of living is through the roof. And unlike some industries, my salary isn’t any different here than it would be in Texas or Mississippi or the Carolinas, states that have a much lower cost of living.
But, in addition to this being our place of birth, my wife and I place a TON of value on the weather, being close to family, and the proximity to various forms of outdoor recreation. There aren’t many places in this country where you can surf, golf, and ski all in the same day.
Our personal preferences could certainly change as we get older, but as it stands today, our money and our spending are highly aligned with our values, and that’s very intentional. Our decision to live in California is not the textbook answer, but it’s our answer.
So, while you might find out through today's episode that there are places you can move that will reduce your tax bill or lower your cost of living, it’s just as important to take the non-financials into consideration. What’s important to you? What do you value most? How and where do you want to spend the final decades of your life?
Once again, to grab the links and resources mentioned in today's episode, just head over to youstaywealthy.com/172.
Thank you, as always, for listening and I will see you back here next week.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.