As people approach retirement, some succumb to the temptation to move south in pursuit of warmer weather, a lower cost of living and lower taxes. Others, like me, make this choice much earlier in life. Regardless of when you consider moving to a lower-tax state, be sure to examine your priorities and the implications of the move.
Why Your State Of Residence Matters
Just as the United States taxes its residents on their worldwide income regardless of where it is earned, states also have the authority to tax all of their residents’ income, not only that they earn in the state. Generally, if you earn income directly connected or attributable to another state, that state also has the right to tax it, even if you are not a resident. However, your resident state will typically allow a credit for that tax, so you are not double taxed on out-of-state income. After accounting for credits, you wind up incurring the tax of the state where you earn the income or where you reside, whichever is higher. Because your state of residence determines the state taxes you will owe, it pays to live in a low-tax state.
A dollar you do not spend on taxes is a dollar that you can use to improve your lifestyle, accelerate your retirement or increase the amount you can leave to heirs or charity. Tax planning, in general, can have a very significant impact on your financial well-being. Since state tax rates are not as high as federal tax rates, the potential savings from state tax planning are less in most cases. Nonetheless, it makes sense to plan for state taxes because it is easier to move between states than it is to escape the taxing power of the Internal Revenue Service. Higher-income earners can still save a great deal by living in a tax-friendly state. These savings compound over time, so the earlier you move, the better.
That said, taxes are just one part of a budget, and their impact should not be inflated when making life decisions. I was able to move from a high-tax state (New York) to a low-tax state (Texas) while keeping the same career with Palisades Hudson. When thinking about a move, evaluate the income potential and cost of living in your new home state, not only its tax rates. In analyzing these numbers, use estimates specific to your lifestyle instead of general cost-of-living metrics. Consider both one-time and added recurring costs that you might incur as a result of the move. Remember that nonfinancial considerations, such as family, may trump the potential savings of making a move.
An interstate move can also create some one-time tax consequences. If you are moving for your job and you meet certain criteria, you may be able to deduct some moving expenses on your federal tax return. Assuming you move sometime other than at the very beginning or the very end of the year, you will probably need to pay close attention to how many days you lived in each place to determine how to handle your nonresident or part-year resident returns for the year of your move.
Choosing The Right Low-Tax State
Lists of tax-friendly states invariably include the seven states that do not levy personal income taxes. These include the warm-weather states of Florida, Nevada and Texas, but also the cooler states of Alaska, South Dakota, Washington and Wyoming.
Of the 43 states that tax personal income, each has a unique tax code, and some cities and municipalities levy their own taxes, too. Most states charge different rates based on how much the taxpayer earns, while eight states simply impose a flat percentage on all income. The type of income also can make a difference in the tax. For instance, many states exclude a portion of Social Security benefits, pension income or retirement plan distributions from their calculations of taxable income. Two states, New Hampshire and Tennessee, tax only dividend and investment income.
While income taxes are an important starting consideration, a comprehensive analysis of how tax-friendly a state will be for you should also incorporate sales and property tax levels. Five states — Alaska, Delaware, Montana, New Hampshire and Oregon — do not impose statewide sales taxes, though some do permit local or city-level sales taxes. And while it is sometimes hard to compare property taxes among states since different governments calculate them differently, the Tax Foundation found that when adjusting for these variables, New Jersey and Illinois imposed the highest effective average property taxes, while Hawaii and Alabama had the lowest.
You should also factor in any other taxes you are likely to face. For example, you may need to compare state inheritance, estate or gift tax rules. Fourteen states and the District of Columbia impose estate taxes, and six impose inheritance taxes. Maryland and New Jersey impose both. For wealthier individuals, considering the different state transfer taxes can be just as important as evaluating the different income tax rates.
Forbes recently calculated the effective overall tax rate, including income, sales and property taxes, for a single taxpayer earning $50,000 in taxable annual income. For such a hypothetical taxpayer, the publication settled on Wyoming as the lowest-tax option, with Alaska, South Dakota, Texas and Louisiana rounding out the top five. The least tax-friendly state? New York. While the most tax-friendly state for a particular high-income taxpayer will depend on specific circumstances, New York and California are particularly unfriendly to almost everyone.
The Difficulties Of Leaving A High-Tax State
Once you have decided that you want to move to a lower-tax state, you may find it more difficult than you expected. State governments benefit from defining residents narrowly when determining benefits such as in-state tuition for college or homestead exemptions on property taxes, but they are often much more broad-minded when determining whether they retain a right to tax an individual’s worldwide income. To protect their revenue sources, states with high income tax rates often take extreme measures to avoid letting their residents go.
Although the prospect of a clash with tax authorities can add to the stress of a typical move, relocating to a lower-tax state can still yield excellent financial benefits if you plan carefully. Generally, the burden will fall on you to demonstrate that you have abandoned your old permanent, primary home — or domicile — in favor of establishing a domicile in your new state. Abandoning a domicile in a state such as Nevada, which has no personal income tax, is significantly easier than abandoning a domicile in a high-tax state such as New York. But the latter can still be done.
Making a clean, swift and well-documented move is your best bet for avoiding a tax dispute. It will help to save moving receipts and dated copies of the lease or closing documents on your new home. But that alone will not be enough. The more substantial a paper trail you can create, the better. Transfer your voter registration, driver’s license and vehicle registrations to your new state as soon as possible. Update your mailing address on your financial accounts and bills right away.
You will want to notify your former state’s tax authorities of the change as soon as you practically can. Renounce any homestead exemption you may have claimed in your old state, and claim such an exemption in your new state if one exists.
Depending on the reason you moved, you may need to look for a new job locally. Or, if you moved for work, bringing your family with you will help establish that you intend to stay in your new home indefinitely. The same goes for bringing your pets, as well as valuable or sentimentally important possessions. Establish ties to gyms, churches or professional organizations in your new state. While no one person will do all of these things in establishing a new domicile, the idea is to create a big picture that makes clear that your move is a permanent lifestyle change rather than simply an attempt to avoid paying income tax while keeping a foot in your old state.
Of course, there may be compelling reasons you cannot immediately sever all ties with your former home. You may have parents or adult children who remain there. Or your business’s main office may need you to visit in person a certain number of days per year. You may simply wish to keep enjoying aspects of your old home. These realities can mean a slightly more complicated move.
If you plan to spend significant time in your old state, keep a careful travel log with receipts, confirmations and other evidence of where you traveled and when. Most states have a threshold for determining residency status, often 183 days or more spent in a state per year. You will want to be sure you stay under that threshold in the old state and above it in the new one. My colleague Laurie Samay recently wrote an article, “How Do You Know If Your Domicile Has Changed?” that offers more detail on how to navigate proving a change in domicile.
All of this may seem like a lot of work in the middle of an already stressful moving process, but planning ahead can pay off handsomely. High-tax states such as New York and California have aggressively pursued residents who depart for more tax-friendly climates to the point where some critics call the process, in essence, an “exit tax.” Whether you would go that far in characterizing tax authorities’ efforts, the audit and appeal process is unpleasant, expensive and often time-consuming. The more thoroughly and promptly you can demonstrate your change in domicile, the better off you will be.
With a better understanding of how an interstate relocation can impact your taxes, you can decide whether you are ready to join me in making the move.