Updating State and Local Tax Burdens

State tax codes are being shaken up, and that could shake up your retirement plans. State and local taxes are growing in absolute terms and relative to federal taxes. Total taxes paid are among the top three expenses for many retirees, and the share of state and local taxes is rising.

We review the state tax picture every couple of years or so. Dramatic changes occurred the last two years and more are planned. You might find significant tax savings are available by changing your residence, and some who moved for low taxes might find some of those savings were legislated away.

I don’t recommend moving solely for tax reasons. It costs a lot of money to move. There is more to consider about a location than taxes. You probably want to be near people you care about and activities you enjoy. Some people put a priority on good medical facilities and other factors. But your tax burden will vary greatly based on where you live, so taxes are a factor to consider.

Consider more than just “headline numbers” such as the income tax rate or the lack of one. You need to estimate the total tax burden, including all state and local taxes, for your income and expenses.

For example, Pennsylvania generally is considered a medium-to-high tax state. Yet, retirees live income-tax-free when they have no earned income. They also benefit from other tax breaks, such as a reduced automobile registration fee and a $250 annual tax credit. Michigan is another high-tax state that provides a tax haven for retirees by not taxing up to $90,240 of pension income. Over $20,000 of interest, dividends, and capital gains also is exempt, but the amount of that income you exempt reduces the amount of pension income that can be excluded. But the governor proposed scaling back the Michigan tax breaks. I don’t know if it will be enacted. But proposals of this sort are why you need to keep a close eye on state tax proposals before moving, and why you might want to reconsider your choice when state and localities change their laws to counter budget deficits.

Some no-income-tax states might not be the bargain they appear to be. New Hampshire has no income tax, except it taxes interest and dividends and does not let you reduce the income by any deductions or exemptions. Most states with no income taxes have higher-than-average property and sales taxes. By moving to one of these states you could pay the same or higher taxes as you where you are now, you’ll just pay them in a different form.

Don’t be fooled by some low tax rates either. Rhode Island, for example, made headlines by reducing its tax rate from 9.9% to 5.99%. But it also eliminated itemized deductions. In fact, nine states impose their taxes on gross income, not allowing any deductions or exemptions. A number of states differ from the federal tax code. Some don’t allow deductions for IRA contributions. Some don’t allow businesses to deduct accelerated depreciation or loss carryovers. You need to compare the details of your finances with the state’s tax code to be sure of what you’ll pay.

Don’t overlook local taxes. Local taxing power varies greatly, but it can be a major part of a resident’s tax burden.

A good starting place to consider state and local tax burdens is www.RetirementLiving.com. Use it to narrow down your search. Then, verify the current tax rules at both state and local levels, and also check on any proposals to raise taxes.

When you find a hospitable tax environment, you might not want to wait for retirement to move. A pre-retirement move could boost your nest egg. Suppose you operate a business. Maybe this is a business you can base anywhere such as professional services, or maybe you’re convenient to two or more states, such as in the New York, New Jersey, Connecticut area. Part of your retirement plan is to sell the business. In this situation, check state capital gains tax rates. You could save quite a few pennies by moving a couple of years before the sale and being able to report the sale in a state with lower capital gains taxes. This strategy also could be worthwhile when you have a substantial investment portfolio and plan to take significant capital gains. You’ll need to get the details right, so get good tax advice before putting a plan in motion.

RW May 2011