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Tax Planning

How to Reduce Your State Tax Bill in Retirement

Smart strategies for lowering the amount of taxes retirees have to pay every year.

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While living in Iowa City, Brenda Talley did a lot of research as she and her husband, Joe, mulled potential retirement destinations. "I had the luxury of time," says Brenda, who retired about six years before Joe did. She looked at magazines' "best places to retire" lists, contacted chambers of commerce for information packets, and used online resources including cost-of-living calculators.

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The couple considered many places in the U.S., from Florida and Texas to Arizona and New Mexico. “We even looked at foreign countries like Panama and Italy,” she says. But after meticulous research, including in-person visits, the couple now lives in what Brenda, age 65, hopes will be their forever home: Oxford, Miss. “We are snug as a bug in a rug,” she says.

How did the Talleys end up choosing one of the South’s most classic literary haunts, amidst the ghost of William Faulkner and the fame of John Grisham? Three key reasons: cost of living, taxes and climate.

The Talleys, who retired to Oxford in early 2015, say they wanted to live relatively cheaply, rein in taxes and be rid of midwestern winters. Mississippi fit the bill--with a big appeal being that the state doesn’t tax retirement income and offers seniors a big property tax break that exempts $75,000 of home value. “That [break] was extremely attractive,” says Joe, age 70.

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Add in southern hospitality, a heavy helping of social and cultural activities, and an educated and diverse population in a town that’s home to the University of Mississippi, and the Talleys were sold. “We wanted a cozy community,” says Brenda.

State taxes certainly aren’t the only factor retirees weigh when figuring out where to live in their golden years, but taxes can make a big difference in how much income is left over to enjoy those golden years after federal, state and local governments claim their share. Lowering your tax burden could free up cash to take that cruise you dream about, or perhaps buy that classic car you have long had your eye on.

While Iowa isn’t the most expensive place to live, says Brenda, moving to Mississippi cut their costs. “We’re living on $15,000 less per year,” she estimates. “That gives us a lot more wiggle room in our budget.”

USE OUR TOOL: State-by-State Guide to Taxes on Retirees

And although their home is the same size, Brenda says the couple’s property tax bill is now 69% less--saving them about $2,300 a year. Their state income tax bill dropped 100%, to zero. “It’s incredible, no income tax,” says Brenda. “We are living very comfortably, and we don’t need to worry about the bottom line.” With Joe soon to begin required minimum distributions from his retirement accounts, the break on retirement income will be even more valuable to the couple.

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Although Uncle Sam often takes center stage when people think about taxes, paying attention to your state tax burden in retirement can really pay off. The 50 states and the District of Columbia vary widely in how tax-friendly they are to retirees’ income. Some states don’t tax income at all, some don’t tax any retirement income, some will exempt certain amounts of income, and other states will sock you on most every dime.

To compare state tax burdens, you must first pinpoint the streams of income you expect in retirement. Will you have a pension from your employer? Is most of your nest egg housed in traditional IRAs? Will Social Security benefits be a large portion of your income?

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The source of your income can make a big difference in the state bill. If the majority comes from a traditional IRA, you would fare better income-tax-wise in a state that gives IRA withdrawals a free pass, such as Mississippi, rather than a state that only waives income tax on public pensions, such as Kansas.

Many states offer special deals on retirement account distributions and pension payouts. Social Security benefits are 100% exempt from state income tax in most states. If you will rely on income from taxable investments or rental property income, consider a no-income-tax state to free your money.

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But state coffers have to be filled somehow, so keep in mind that if taxes are low to nonexistent on income, levies may be higher in other areas, such as sales tax and property tax. “No-income-tax states get income from somewhere else,” says Gil Charney, a director with the Tax Institute at H&R Block.

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Look at the whole picture. Prescription drugs and groceries are exempt from sales tax in many states, so if you don’t buy a lot of discretionary items, a higher sales tax may have less of an impact. If you love to shop, one of the five states with no state sales tax may have particular appeal. Get out a pencil and paper, or turn to your tablet, and draw up your financial picture in retirement. That will help you determine the tax impact on your retirement income when you compare states’ tax burdens.

Our Take on State Taxes

Once you’ve got an idea of your retirement income, check out Kiplinger’s freshly updated Retiree Tax Map for all the details on how each state taxes retirees. You’ll see which states give special breaks to certain kinds of income. You’ll find property tax breaks for seniors if a state offers them, and you can see each state’s average sales tax burden and median property tax burden. Our comparison tool lets you check as many as five states side by side.

Every year Kiplinger’s makes a call on the 10 most tax-friendly states for retirees and the 10 least tax-friendly states for retirees. This year’s number-one tax-friendly state is Alaska, which has no income tax, no state sales tax and actually pays residents to live there through its annual oil dividend. Vermont takes the crown as the least tax-friendly state for retirees for the second year in a row. The Green Mountain State taxes most retirement income, including up to 85% of Social Security benefits.

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While tax policy sometimes seems to move at a glacial pace, changes do occur, and recently, they have generally been in taxpayers’ favor. “The majority of changes in the last few years are taxpayer friendly, either to keep retirees in the state or to attract retirees from out of state,” says Rocky Mengle, state income tax analyst at CCH, a tax-information publisher.

Rhode Island, for instance, fell off our list of least tax-friendly states this year because of recent moves that benefit retirees. The Ocean State now exempts Social Security benefits completely for individual filers with $80,000 or less in adjusted gross income ($100,000 or less for joint filers). Starting next year, $15,000 of other retirement income will be tax-free. Still, with high property taxes and an estate tax, Rhode Island won’t join the tax-friendliest states just yet.

A recent trend: special breaks for military retirement pay. This year, Maine, Minnesota and South Carolina ushered in new exemptions. Maine and Minnesota now exempt 100% of military retirement benefits. South Carolina is phasing in a new deduction that in 2016 exempts $18,000 of military retirement pay for those 65 and older and $5,900 for those younger than 65; those amounts climb to $30,000 and $17,500, respectively, by 2020. New military retirement exemptions went into effect in Connecticut and Nebraska last year.

TAKE OUR QUIZ: Is It Tax Deductible?

Breaking Down Retirement Income Taxes

So how do the states stack up? Income of all kinds gets a pass in seven states: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming have no state income tax. Two states, New Hampshire and Tennessee, tax only dividends and interest. But Tennessee, which joins our top 10 list this year as the tenth tax-friendliest state for retirees, is phasing out its tax. For tax year 2016, the rate dropped from 6% to 5%, and by 2022, the tax on dividends and interest will be gone for good.

Of the remaining 41 states, plus the District of Columbia, that have an income tax, eight have a flat tax, which imposes a single rate on all residents regardless of income. The other 33 states plus the District impose graduated rates, which tax households with higher incomes at a higher rate.

Most states offer some type of retirement-income exclusion. For example, Mississippi, which ranks as our fourth tax-friendliest state for retirees in 2016, exempts all retirement income, including public and private pensions and distributions from retirement accounts, such as IRAs and 401(k)s.

SEE ALSO: 10 Best States to Live In for Taxes

Other states turn a blind eye to a set amount of retirement income. These amounts vary greatly, from a few hundred bucks to thousands of dollars. Georgia offers the largest exclusion, at $65,000 for a taxpayer 65 or older (couples can exclude $130,000).

Some states offer tax breaks on certain categories of retirement income. Kansas, for example, exempts in-state public pensions but taxes all private retirement income. And two states offer a break only to military retirees: Connecticut makes tax-free 100% of military retirement, and Nebraska lets military retirees exclude part of military retirement income.

Of course, a big part of many retirees’ income is Social Security benefits. While the federal government taxes up to 85% of Social Security, benefits are completely tax-free in most states.

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In addition to the nine states that don’t have a broad-based income tax, Social Security benefits are free from state income taxes in Alabama, Arizona, Arkansas, California, Delaware, Georgia, Hawaii, Idaho, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Michigan, Mississippi, New Jersey, New York, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, South Carolina, Virginia and Wisconsin. D.C. also waives income tax on benefits.

Of the remaining 13 states, Social Security benefits are taxable to some extent. West Virginia, for instance, taxes Social Security benefits the same as the federal government does. Rhode Island joins Connecticut, Kansas, Missouri and Nebraska in using income thresholds that are higher than the federal threshold.

Other Taxes to Consider

“If someone is looking for a place to retire and trying to evaluate the overall tax burden, you have to look beyond state income tax,” says CCH’s Mengle. You have to consider property taxes, state sales taxes, and in some jurisdictions, local income and sales taxes, too. Mengle notes that New York City, for instance, has its own tax system for sales and income taxes.

Five states don’t charge consumers a state sales tax: Alaska, Delaware, Montana, New Hampshire and Oregon. California has the highest state sales tax rate at 7.5%, and five states--Indiana, Mississippi, New Jersey, Rhode Island and Tennessee--tie for the second-highest statewide rate at 7%.

In 38 states, including Alaska and Montana, local sales taxes are collected. The three states with the highest average combined state and local sales tax rates are Louisiana (9.99%), Tennessee (9.45%) and Arkansas (9.30%), according to research by the Tax Foundation. The three states with the lowest average combined rates are Alaska (1.78%), Hawaii (4.35%) and Wisconsin (5.41%).

If you plan to own a home, property taxes are another tax factor to figure. (Renters share this burden, too, since landlords often pass on the cost.) Based on Kiplinger calculations using U.S. Census data, New Jersey has the highest property tax burden. With the Garden State’s median real estate taxes of $7,452 on a median home value of $313,200, property taxes account for 2.38% of home value. Hawaii came in lowest at 0.27%, with median real estate taxes of $1,401 on a median home value of $528,000. Because local taxing authorities can affect property tax rates, property tax bills can vary widely even within a state, says Mengle.

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But those figures don’t account for extra sweeteners that retirees may qualify for. Many states offer retirees property tax breaks, which typically have age and/or income thresholds. But if you qualify, you may significantly reduce your tax bill. Mississippi homeowners age 65 and older get a pass on the first $75,000 of home value, so owning a home at the state’s median home value of $104,000 means owing property tax on only $29,000. In Oxford, that would result in a property tax bill of a few hundred dollars.