Editor's Note: Our 2009 retirement tax story can be read here.
Some states are more tax-friendly for retirees than others. And how much you pay in taxes -- particularly if you are living on a fixed income -- can have a big impact on how much you have left over to spend.
If you're thinking about relocating permanently or buying a second home to live in for part of the year (and where you may be taxed on part of your income), don't make a move until you've scrutinized the whole financial picture in your potential new home.
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Your federal taxes will be the same no matter where you live, but you may be surprised at how much your state and local tax burden can vary from one location to another. "You can save thousands of dollars a year by moving from a tax hell to a tax haven," says Mary Lu Abbott, editor of Where to Retire magazine.
Don't assume that a state with no income tax qualifies as a tax haven. High sales and property taxes can more than offset the absence of an income tax, says Abbott. (Seven states -- including Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming -- have no state income tax. New Hampshire and Tennessee tax only dividend and interest income that exceeds certain limits.)
In addition, the tax bite can vary greatly within a single state. For example, a retired couple with an annual income of $90,000 and a home worth $525,000 would pay about $13,000 in total state taxes if they lived in Fort Lauderdale, Fla. -- but only $9,000 if they lived across the state in Siesta Key. The contrast is due mainly to differences in property taxes, says Abbott. By comparison, if the same couple lived on Hilton Head Island, they would pay less than $6,600 in total taxes because although South Carolina has an income tax, it has relatively low property taxes.
Abbott drew her examples from her company's sister publication, America's Best Low-Tax Retirement Towns ($18.95, Vacation Publications). The book rates the total tax burden for more than 200 cities, broken down by different income levels and home values -- a good starting point if you're trying to determine the financial implications of moving or staying put.
But there's no substitute for calculating the taxes you would actually pay in a potential new home, says Paul Erickson, a professor of taxation at Baylor University, in Waco, Tex. "There are too many differences in tax rates, brackets, exclusions and deductions," says Erickson. (You can download state income-tax forms from www.taxsites.com or prepare a sample state-tax form with software such as TurboTax.)
Most people choose a retirement destination based on a combination of factors, including climate, access to quality health care and the general cost of living. "Obviously, a decision should not be based on taxes alone," says Erickson. "But if other factors are relatively equal, a substantial difference in tax burden may dictate the best retirement location."
All 50 states and the district of Columbia determine their own tax treatment of retirement income. Only three states -- Illinois, Mississippi and Pennsylvania -- exempt virtually all retirement income (including public and private pension benefits, 401(k) and other retirement-plan distributions, and IRA withdrawals) from state income taxes. Seven states -- Alabama, Hawaii, Kansas, Louisiana, Massachusetts, Michigan and New York -- FULLY exempt government and military pensions from state income taxes. Those same seven states treat private pensions differently, ranging from no exemption in Massachusetts to a tax exemption up to certain dollar limits in Michigan and New York. Alabama and Hawaii exempt income from traditional pensions funded by employers but tax some or all of retirement income from employee-funded plans. Seven other states -- Delaware, Georgia, Minnesota, New Mexico, Utah, Virginia and West Virginia -- provide a partial exemption for retirement income, regardless of the source.