The Most Tax-Friendly States For Retirees: How To Compare State Income Tax Options For Retiring Clients

The Most Tax-Friendly States For Retirees: How To Compare State Income Tax Options For Retiring Clients

As an individual begins planning for retirement, one of the factors often considered is whether (and where) they might relocate to enjoy their retirement. When evaluating their potential options across the U.S., a state’s income tax rules can have a significant impact on where they might choose to live. The perception of a state as having high or low taxes could make it more or less attractive for someone choosing where to relocate, and those perceptions are often skewed by the state’s ‘headline’ tax rate (that is, the top tax rate imposed on the highest income tax bracket), meaning that states that don’t tax any income at all are often given extra consideration, while those that tax income at the highest rates tend to get crossed off the list fairly early.

In reality, however, the top marginal rates don’t usually tell the whole story – at least not for retirees. That’s because many states (including those typically labeled as “high-tax”) feature a slew of different tax breaks that can significantly reduce the tax burden for retirees in those states. As a result, the list of states where a typical (or even higher-income) retiree would pay very little or even zero tax might be much larger than what might be assumed based on the top marginal rates alone.

State tax breaks for retirees usually come in 4 flavors: no income tax at all; exclusion of Social Security income from taxable income; exclusion of pension or retirement plan withdrawals; and additional exemptions, deductions, or credits for all taxpayers above certain age thresholds. Every state in the U.S., plus the District of Columbia, features at least one of these types of tax breaks benefiting retirees, and many have more than one, meaning that retirees with a combination of Social Security, pension, and even other types of income (like dividends and interest or income from working a job) will almost always pay a lower overall tax rate on their income than those who are still working full-time.

The tricky part, however, is navigating the many nuances and exceptions included in the different tax codes of the 50 states. Many states either have income-based limitations on the tax benefits that higher-income retirees can realize, while others cap the total amount of retirement tax benefits that an individual can use (for example, by setting a maximum amount of combined Social Security and/or pension income that can be deducted from a taxpayer’s income). As part of the final decision, therefore, it’s often advantageous to do more in-depth tax planning to recognize some of the planning opportunities or pitfalls that could come with retiring to a certain state.

The key point is that even though it might not be necessary to attain a thorough grasp of all 50 states’ tax policies, knowing some of the key elements to look for when considering a given state – like whether or not (and how much) Social Security or retirement plan income is taxed; the treatment of interest, dividends, and capital gains; and what other potential deductions or exemptions might be available for taxpayers after a certain age – can create a deeper understanding of the true impact of income tax from living in a certain state. And for some future retirees, it might even expand the potential list of states beyond what they previously considered affordable!

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