Author Jeff Stimpson
Deferring taxes by contributing to an individual retirement account or 401(k) while living in a high-tax state, then moving to a lower-tax state before retiring and tapping the accounts, is a viable way to legally avoid state taxes. But it’s not always an easy tactic to carry out.
Underlying the strategy is the simple fact that distributions from retirement accounts are taxed in the state of residence. But what’s not so simple in some cases is establishing a taxpayer’s home state, advisors said.
“Waiting to withdraw tax deferred retirement accounts until you’ve moved to a low- or no-income tax state will work,” said Steve Parrish, St. Augustine, Fla-based co-director of the American College of Financial Service Center for Retirement Income. “The biggest issue is where you call home for tax purposes.”
Other considerations, Lau said, include sale of a residence in the former state, how much the taxpayer needs to withdraw from retirement accounts, life expectancy and the presence of children or grandchildren, said John Lau, managing director at Robertson Stephens Wealth Management in San Francisco.
Still, it’s a worthwhile strategy to pursue, advisors said.
“State income taxes should be a factor when deciding where to reside come retirement,” said Adam Beckerink, Duane Morris Corporate Tax Partner in Chicago. “Some states have no individual income taxes while other states do not tax social security benefits or IRA distributions.”
The savings can be significant. “The top tax rate in California is over 13%, while its neighbor Nevada has no income tax,” said Tim Steffen, Milwaukee-based director of Advanced Planning for Baird. “Or take Vermont, which has a top rate of 8.75%, but right next to it is New Hampshire, which only taxes interest and dividend income, not retirement income.”
“Some states tax these amounts similar to other income with no preferential treatment, added Jim Brandenburg, a CPA and Milwaukee-based tax partner at the national professional services firm Sikich. “Other states that have an income tax don’t tax retirement income.” Savings can also be found in portfolio income such as interest, dividends, and capital gains, Brandenburg said
Conventional wisdom says 183 days of the year in a state constitutes residency. But details of residency are more complex these days as more states pursue residency audits that look at business ties to the former state and maintaining a large personal residence in the former state, as well as location of voter registration, driver’s and sporting licenses, wills, doctors and places of worship, among others. The real complexity comes for people who want to straddle the fence with homes in two states, Steffen said.
“If you’re a snowbird, spending the winter months in Florida or Texas, it’s important to consult with your tax advisor as to which state is your state of residency, as that state may be able to tax all your income,” said Eric Fader, Duane Morris special counsel in Chicago. “There are numerous cases in all the states with regard to residency determinations—getting a driver’s license in a no-tax state is not enough to establish residency.”
Picking a state in the first place requires homework. “Some states that have an income tax don’t tax pension income as an inducement to attract retirees,” said Stephen Brownell, partner-in-charge of Eisner Advisory Group’s San Diego office. When deciding on where to retire, other taxes should be considered, he said, including sales tax rates, property tax and possibly estate and inheritance taxes—not to mention drawbacks such as the level and cost of other services like healthcare.
“Most states with income tax follow the same rules for taxing IRA distributions as the federal government, treating distributions as taxable income [and] contributions are tax deductible,” said Jeff Mattonelli, financial advisor at Van Leeuwen & Company in Princeton, N.J. “A few states do not allow you to deduct your IRA contributions and therefore your distributions may be treated differently as well.”
It’s hard to do too much homework before such a move, advisors said.
“You may not get the overall savings you expect,” Parrish said, noting that in some states the lack of an income tax could be offset by high property and sales taxes. “If your taxable income is low and your purchases or property is high, you may not come out ahead.”