Ah, retirement. The very sound of the word is music to the ears of millions of older workers, especially those who will be financially prepared to stop working. No boss, no schedule, long days of leisure down in sunny Florida … or Arizona … or maybe California. Which state should you choose, anyway? Of course, there is no right answer to this question, but the state in which you choose to retire will affect how far your retirement dollars will go. Let's take a look at the types of taxation levied by different states and how this can impact your financial well-being in your golden years. (For further reading, check out Managing Your Income During Retirement.)

SEE: Simple Ways to Save In Retirement

It All Depends
From a tax perspective, determining which state is the "right" state to retire in will depend on the type and amount of income that you reasonably expect to receive. The nine states that, as of 2008, do not assess income tax of any kind (Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming, Tennessee and New Hampshire) do not automatically qualify as the best for all retirees. If you own several rental properties, then the best state for you may differ from someone whose primary income outside of Social Security will come from pensions or IRAs.

There are four major categories of income for which states differ in their methods of taxation:

  • Pensions
  • Social Security
  • Sales Tax
  • Property Tax

Pension Income
If you're looking to escape taxation of your pension at the state level, your options are pretty limited. As of 2009, there are only three states that do not tax pension income:

  • Illinois
  • Mississippi
  • Pennsylvania

New York has stipulations for some government employees to receive tax-free pension income, but not all retirees. These three states exempt virtually any kind of income received from tax-deferred accounts, including pensions, IRAs and qualified plans. (For more on the latter, check out Tough Times...Should You Disturb Your Qualified Plan's Assets?)

If your pension is from the government or the military, then seven more states open up for consideration: Alabama, Hawaii, Kansas, Louisiana, Massachusetts, Michigan and New York.

If the aforementioned states do not appeal to you as retirement havens, seven others exempt at least a portion of pension income from taxation: Delaware, Georgia, Minnesota, New Mexico, Utah, Virginia and West Virginia.

States that tax all retirement income at relatively high rates include California, Connecticut, Nebraska, Rhode Island and Vermont. More complete information on how each state taxes their residents' pension income can be found at RetirementLiving.com.

Social Security Benefits
Retirees seeking relief from Social Security taxation at the state level have far more choices than those who do not want to pay taxes on their pension income. In addition to the nine income-tax-free states, as of 2009 (New Hampshire and Tennessee only tax dividend and interest income), there are 27 more (plus WashingtonD.C.) that exempt Social Security benefits from taxation.

The remaining states all tax Social Security income to some degree, although several of them have imposed various types of limits that apply when calculating the amount owed on this income. (For more on avoiding unnecessary tax on your Social Security income, read Avoid The Social Security Tax Trap.)

Sales Taxes
Some states choose to tax their residents in their capacities as consumers instead of earners or income recipients. Of course, some states do this in more ways than others. Certain states tax everything except food and medical expenses, while others have no such exclusions. Then there are four states that (as of 2009) impose no sales tax of any kind: Alaska, Montana, New Hampshire and Oregon. (Read more about sales tax in Do Tax Cuts Stimulate The Economy?)

But retirees weighing these options should take care to research the sales taxes imposed at the city and local levels within each state as well (this is a rapidly growing trend). (Retirees who have municipal bonds as part of their portfolio should be sure to read Retirees Can't Count On Muni Bonds.)

Property Taxes
Retirees with substantial real estate holdings should perhaps pay more attention to this category of taxation more than any other except perhaps taxation of income. However, retirees who live on fixed incomes and own their own homes should carefully examine this category as well. Taxes assessed at the city and local levels should be thoroughly researched here as well, as they can play a substantial role in the overall amount the property owner will be assessed. (Property ownership might not be the right decision for all retirees. Read Retirement Living: Renting Vs. Home Ownership for more information.)

However, the current tax rates may not tell the whole story; a history of rising or falling rates will most likely impact the amount of tax that you pay over time as well. Of course, property tax rates are ultimately driven by real estate values, and therefore they are impacted by the usual factors such as population, location and proximity to interstates, municipalities and thoroughfares. Furthermore, many cities and localities base their property tax rates on different formulas, with some using a much greater percentage of a property's market value than others. (To learn more, check out Five Tricks For Lowering Your Property Tax.)

Case Study - Deciding Where To Retire
Carl Riken and his wife, Julie, are considering moving to Arizona. Between his job and his sideline of rehabbing houses, Carl has made a good living in his current state of residence. But Carl intends to continue his sideline in Arizona after he quits his current job and moves there. (Read more about having a working retirement in Stretch Your Savings By Working Into Your 70s.)
Carl should therefore closely examine not only the income tax rates in Arizona at both the state level and among the localities in which he may choose to live, but property taxes as well, which can substantially impact the net revenue that he will receive from his rehab business.

The Bottom Line
This article only broaches the differences in how states collect revenue from their citizens. Those who are seriously considering living in a particular state would be wise to visit that state's Department of Revenue website and should probably consult a tax advisor who works in that state as well.

For further reading, see Five Tax(ing) Retirement Mistakes.

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