Overview of Retirement Tax Friendliness
Retirees have specific financial concerns and some states have taxes that are friendlier to those needs. Of special interest to retirees are generally issues such as whether Social Security benefits are taxable at the state level, what property taxes will be levied and how retirement account and pension withdrawals are taxed.
Very Tax FriendlyStates that either have no state income tax, no tax on retirement income, or a significant tax deduction on retirement income. In addition, states in this category have friendly sales, property, estate and inheritance tax rates.
Tax FriendlyStates that do not tax Social Security income and offer an additional deduction on some or all other forms of retirement income. Generally, states in this category also have relatively friendly sales, property, estate, inheritance and income tax rates.
Moderately Tax FriendlyStates that offer smaller deductions on some or all forms of retirement income. The sales, property, estate, inheritance and income tax rates in this category range in friendliness based on the degree of retirement deductions available.
Not Tax FriendlyStates that offer minimal to no retirement income tax benefits. These states also do not have particularly friendly sales, property, estate and inheritance tax rates.
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Retirement Tax Friendliness
For seniors who plan to move to a new city or state for their retirement, there are a number of factors to consider. Weather is important to many retirees, as are amenities and attractions such as golf courses, beaches, parks and senior centers. Another major consideration is the cost of living in a certain area. Taxes are a big part of that.
State and local taxes can have a particularly significant effect on retirees. As described below, income taxes on things like Social Security retirement benefits and retirement account withdrawals vary widely from one state to the next. Likewise, there are vast differences between the property and sales tax rates across the country.
In short, the taxes seniors pay during retirement can vary greatly depending on where they live. In a state like Wyoming, which has no income tax along with low sales and property taxes, retirees can expect to have a very small tax bill. On the other hand, taxes in a state like Nebraska, which taxes all retirement income and has high property tax rates, the overall state and local tax bill for a senior could be thousands of dollars higher.
A financial advisor can help you plan for retirement and other financial goals. Financial advisors can also help with investing and financial plans, including taxes, homeownership, insurance and estate planning, to make sure you are preparing for the future.
Most states do not tax Social Security income at all. Some of these, like Texas and Florida, do not have an income tax. Others provide a specific deduction or exemption for Social Security retirement benefits.
Among the 13 states that do tax Social Security income in some way, seven provide some sort of deduction or credit to limit or offset the cost of the tax for retirees. The remaining six states (Minnesota, North Dakota, Nebraska, Rhode Island, Vermont and West Virginia) tax all Social Security income that is taxed at the federal level.
Retirement Account and Pension Income
The way a state handles retirement account and pension income can have a huge impact on the finances of a retiree. 22 states do not provide any kind of deduction, exemption or credit on withdrawals from a retirement account such as a 401(k) or IRA.
How might that affect a typical retiree? Let’s say your effective state tax rate in one of these states is 4% and your annual income from your 401(k) is $30,000. That would add up to taxes of $1,200 on that retirement account income — taxes that you wouldn’t have to pay in states like Alaska (which has no income tax) and Mississippi (which exempts retirement account income).
Exemptions for pension income are more common. Only nine states fully tax income from a government pension, while sixteen tax income from a private employer pension. The other states either exempt that income or provide a deduction or credit against it.
Property Taxes and Senior Property Tax Relief Programs
Homeownership is a good way for seniors to lock in their housing costs for the long run so that they don’t have to worry about shifts in the housing or rental market. In some states, however, high property taxes or property taxes that can grow rapidly from one year to the next serve to discourage retirees from owning a home. Property tax rates and rules are drastically different between states.
For example, in New Jersey most homeowners spend at least $7,800 annually in property taxes. In Alabama, most homeowners spend less than $600.
One way many states help retirees limit the burden of property taxes is by offering exemptions or circuit breakers. The terminology varies by state, but exemptions (sometimes called homestead exemptions) typically allow seniors to protect part of their home’s value from property taxes. They often have income limits, so households earning more than a certain amount are not eligible.
Circuit breakers can have the same effect as an exemption. Sometimes, they also limit the amount property taxes can increase from one year to the next for seniors.
Property tax deferrals are another helpful form of property tax relief for seniors. Deferrals allow seniors and retirees to put off payment of some or all of their property taxes until a later time. It is typical for deferred property tax payments to be subtracted from the revenue of an eventual home sale, meaning they never come out of a senior’s income.
It is easy to overlook or forget about sales tax because they are paid gradually instead of all at once. You don’t receive a sales tax bill, in other words. But sales taxes are important for seniors because they often have a fixed income and spend a significant portion of that income on potentially taxable items.
Four states (Oregon, New Hampshire, Montana and Delaware) have no state or local sales taxes. Alaska has no state sales tax but does have some local sales taxes. Hawaii has a general excise tax (GET) that is very similar to a sales tax (though at 4.00% it would be the lowest sales tax in the U.S.). In the remaining states, total state and average local tax rates range from 5.36% to 9.47%. Tennessee has the highest sales tax rates in the U.S.
Most states with a sales tax provide a number of exemptions that benefit seniors. The most common exemptions are for groceries, prescription drugs and medical equipment.
Estate and Inheritance Taxes
Another type of tax that is of particular importance to retirees is the estate tax. In recent years, legislatures across the U.S. have either repealed their state estate taxes or have increased the local estate tax exemption. (The estate tax exemption is the limit below which estates do not owe taxes.)
States are largely following the federal government’s lead. The federal estate tax exemption has increased over the years from $675,000 to $11.4 million today. Of the 12 states (and Washington, D.C.) that have their own estate tax, 10 have an exemption of less than $4 million. Massachusetts and Oregon have the lowest exemption at $1,000,000.
Similar to the estate tax, an inheritance tax affects property that is passed on to loved ones (or strangers). The tax applies not to the estate itself, but to the recipients of property from that estate. For example if you receive $1,000 in inheritance and are subject to a 10% inheritance tax, you would pay $100 back in taxes.
Six states have an inheritance tax. Of these, one state (Maryland) also has an estate tax. Inheritance taxes typically provide exemptions or lower rates for direct family members, while fully taxing non-relatives.
Most Tax Friendly Places for Retirees
SmartAsset’s interactive map highlights the places in the country with tax policies that are most favorable to retirees. Zoom between states and the national map to see the most tax-friendly places in each area of the country.
Methodology To find the most tax friendly places for retirees, our study analyzed how the tax policies of each city would impact a theoretical retiree with an annual income of $50,000. Our analysis assumes a retiree receiving $15,000 from Social Security benefits, $10,000 from a private pension, $10,000 in wages and $15,000 from a retirement savings account like a 401(k) or IRA.
To calculate the expected income tax this person would pay in each location, we applied the relevant deductions and exemptions. This included the standard deduction, personal exemption and deductions for each specific type of retirement income. We then calculated how much this person would pay in income tax at federal, state, county and local levels.
We calculated the effective property tax rate by dividing median property tax paid by median home value for each city.
In order to determine sales tax burden we estimated that 35% of take-home (after-tax) pay is spent on taxable goods. We multiplied the average sales tax rate for a city by the household income after subtracting income tax. This product is then multiplied by 35% to estimate the sales tax paid.
For fuel taxes, we first distributed statewide vehicle miles traveled to the city level using the number of vehicles in each county. We then calculated miles driven per capita in each city. Using the nationwide average fuel economy, we calculated the average gallons of gas used per capita in each city and multiplied that by the fuel tax.
For each city we determined whether or not Social Security income was taxable.
Finally, we created an overall index weighted to best capture the taxes that most affect retirees. The income tax category made up 40% of the index, property taxes accounted for 30%, sales taxes 20% and fuel taxes 10%.
Sources: Internal Revenue Service, Social Security Administration, state websites, local government websites, US Census Bureau 2018 American Community Survey, Avalara, American Petroleum Institute, GasBuddy, UMTRI, Federal Highway Administration