Retiree Tax Heaven (and Hell)

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."

Pensions

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.

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Five states are particularly tough on retirees. Not only do they fully tax most pensions and other retirement income, but most of them also have fairly high top tax brackets, says Tom Wetzel, president of the Retirement Living Information Center. Those states, with their top tax brackets for 2008, are California (9.3%), Connecticut (5%), Nebraska (6.8%), Rhode Island (9.9%) and Vermont (9.5%). For a free state-by-state tax guide, including exemptions for seniors and a rundown on how various types of retirement income are taxed, go to www.retirementliving.com.

Social Security Benefits

Most states are moving away from taxing Social Security benefits. In addition to the nine states that do not have a broad-based individual income tax, 27 states and the District of Columbia don't tax Social Security. Wisconsin was the latest to join those ranks in 2008.

The remaining 14 states -- Colorado, Connecticut, Iowa, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont and West Virginia -- tax Social Security benefits to some extent.

Iowa will gradually phase out its Social Security tax by 2014, starting in 2008. Missouri will increase the amount of Social Security benefits that may be deducted from taxable state income, rising from 35% in 2008 to 100% in 2012 and beyond. Kansas residents can now exclude Social Security income from their taxes if their adjusted gross income is less than $75,000, up from $50,000 in 2007.

There's no guarantee that this trend of exempting Social Security benefits from taxes will continue, says Kathleen Thies, state-tax analyst for CCH, a major provider of tax information. "But many states seem to be heading in that direction as their populations age and tax treatment of Social Security income becomes a bigger priority for voters."

Sales Taxes

If you're considering a move to another state, don't forget to take into account sales taxes that can nick your wallet every time you open it. Some states exempt food and medicine; others tax every dime you spend. Five states -- Alaska, Delaware, Montana, New Hampshire and Oregon -- have no state sales taxes. At the other extreme, five states -- Indiana, Mississippi, New Jersey, Rhode Island and Tennessee -- each have a state sales tax of 7%, the highest in the nation. Last year, South Carolina raised its statewide sales-tax rate from 5% to 6%. In 2008, Maryland went from 5% to 6%, and Indiana from 6% to 7%.

Eight states impose a sales tax only at the state level: Connecticut, Indiana, Kentucky, Maine, Maryland, Massachusetts, Michigan and Rhode Island. But the retail-tax pain doesn't always stop at the state level. In many states, cities and other local governments can slap their own sales tax on top of the state levy, and they're doing so in record numbers. In 2007, 485 U.S. cities either increased their sales-tax rate or initiated a new sales tax.

That was the largest annual expansion in the past four years, according to the annual sales-tax-rate study by Vertex, of Berwyn, Pa. "It is evident from the slew of cities raising sales tax rates last year that local governments see tax revenue as a viable part of the solution in addressing revenue shortfall," says Vertex's John Minassian.

Property Taxes

Property taxes are a major factor, especially for individuals on a fixed income. Tax rates vary significantly from state to state and municipality to municipality. Don't look only at existing property-tax rates, says Thies; ask how property taxes have changed over the years. "If you're moving into an up-and-coming area versus one that is more mature, or if you are moving into an area that is gentrifying, you may find your property taxes increasing at a higher-than-anticipated rate."

It's particularly difficult to compare real estate taxes because local jurisdictions follow different assessment and reporting procedures. For example, real estate taxes in Florida are based on 100% of market value, while homes in South Carolina are assessed at 4% of market value. And some jurisdictions with relatively low real estate taxes are located in areas that have above-average real estate values.

Based on data from a 2006 Census Bureau survey and Tax Foundation calculations, the five states with the lowest median real estate taxes (from lowest to highest) are Louisiana, Alabama, West Virginia, Mississippi and Arkansas. The states with the highest median real estate taxes (from highest to lowest) are New Jersey, New Hampshire, Connecticut, New York and Massachusetts.