When I first visited California at the age of thirty, it was love at first sight. We flew into Los Angeles for a stunning wedding in Laguna Beach; drove up the stunning Pacific Coast Highway; hiked the stunning edifice of Half Dome in Yosemite; wandered the steep, hip (and stunning) streets of San Francisco; and recovered with more than a few stunning glasses of Cabernet in Napa. Gazing in a contented haze over rolling vineyards which stretched to the horizon, I heard a faint, angelic voice inside my head:
“Wouldn’t it be lovely to live in California, Dr. Curious? Maybe you should retire here?”
Almost immediately another voice answered. It was a harsh, nasal voice with a Michigan accent: my personal finance demon.
“Oh, you can’t live here. Do you know how high the taxes are? It’s too expensive.”
At least, that’s what I always thought.
Location, location, location
Where you choose to live is one of the most important factors affecting eventual financial success—right up there with salary and savings rate. The location at which you literally hang your hat each day determines cost of living, income tax, housing cost, property tax, sales tax, and even lifestyle choices, especially if you strive to keep with the Joneses. Expenses vary by state, city, neighborhood, house, and perhaps even by room (I tend to purchase more from Amazon in my dining room).
I want to delve deeper into the truth behind one of these expenses—state income tax—as it pertains to my specific situation as an early retiree. My question: How much does the state in which I reside during retirement affect my taxes?
Assumptions
First, let me outline a few assumptions I made for this exercise.
I outlined the details of my retirement budget in a previous post, and here is a summary of those projected fixed monthly expenses:
To this total I added an additional $5000/month for discretionary spending, putting my projected annual expenses in early retirement at $120,000.
A few additional assumptions:
- Married filing jointly.
- No earned income. All of my expenses in the early years of early retirement will come from dividends and the sale of taxable mutual funds.
- No federal capital gains taxes. What? How can I assume this? As detailed in this post, $120,000 may be the amount I deposit in my bank account to cover expenses, but it is not my taxable income. My calculations estimate that only $70k of that $120k represents taxable investment income (dividends and long-term capital gains), with the remaining $50k representing the cost basis of those assets at the time of purchase. Thus, my taxable income of $70k is just inside the 15% tax bracket and the 0% LT capital gains bracket.
- State-specific standard deductions, exemptions, and tax credits. These can vary substantially among states. I assumed four exemptions—married filing jointly with two dependents—because that is me!
State tax confusion
One fact I discovered through this exercise is that states tax capital gains and dividends as ordinary income (except for Tennessee; see table caption). States shows no mercy for investments like the feds do. Income is income.
One a more pleasant note, my tax burden (federal + state) will be no more than 4.5% of my total income, no matter where I live. That’s a welcome and frankly shocking number given what I have paid thus far in my career.
Observations
The west coast states were an interesting triad: Oregon, that greedy hipster, provides the highest tax burden for me; Washington imposes no taxes; and California—which has a reputation as a very high tax state—ranks all the way down at number 37 in my scenario. My retirement dreams are alive!
The reason I imagined the tax burden would so high in California was its top marginal tax rate of 13.3%. However, my expected level of taxable retirement income ($70k) would land squarely in the 6% tax bracket. Quite a few “high tax states” turned out this way. Check out New Jersey: the top marginal rate is 8.97%, but $70k places me in the 2.45% bracket!
Tax brackets are key in the higher tax burden states as well. For Oregon, my highest tax state, the marginal tax rate escalates quickly with income—7% beginning at $6500 and 9% beginning at $16,300.
Any ranking of the “highest tax states” almost invariably uses the top marginal tax rate. As you can see from the table below, these rankings can be quite deceptive when applied to a real-world tax calculation.
Deceptive taxation can work in both directions—both higher and lower relative to expected taxes based on the highest marginal tax rate. In my case, California, New Jersey, and Vermont are lower than anticipated because my income falls into a lower intermediate tax bracket. Kentucky, on the other hand, has tax brackets that escalate quickly—similar to Oregon—resulting in higher than expected taxes for me. Colorado’s higher than expected tax burden reflects the lack of deductions and exemptions combined with a modest flat tax.
Interested in your own retirement tax scenarios for different states? I found the calculators at tax-brackets.org (no affiliation) extremely useful.
Lessons learned
Not only do I enjoy writing these types of posts, but I learn a great deal in researching them. What did I add to my financial education this time?
- State capital gains and dividends are treated like ordinary income.
- Don’t let the state-tax tail wag the dog. In my situation, state taxes don’t matter much. For a projected retirement income of $120,000/yr, I can expect to pay anywhere from $0-$5397/yr ($0-$450/month) in taxes depending in my state of residence. An additional cost of, at most, $450/month will not dissuade me from choosing a retirement locale. I will choose where I want to live based on other factors, such as proximity to vineyards.
- Location affects more than income tax. Housing costs, property taxes and cost of living are particularly impacted by your precise location. Property taxes where I currently reside are over $6000, more than the projected retirement income taxes in any of the above scenarios!
- The devil is in the (tax bracket) details. In order to determine a projected tax burden in retirement, one needs to get into the weeds. What might seem like an expensive tax state at first glance may be less so in your particular situation.
- I might just retire to California.
Which financial considerations have a big impact on where you might retire? Please comment below!
As a fellow California transplant (we really need to get together- forget Napa and come visit me in Sonoma County) I felt the same way. Tennessee, my home state, is a bastion for tax savings for high earners. Sure the sales tax is high, but not capital gains or income tax. Too bad my wife won’t move back and the weather here is too good to pass up on.
For me, property tax is the biggest concern of retiring in Cali. I currently pay $16,500 in property tax. Now we could downsize, but even if we did so and wanted to live in the city (I do not want to retire to the country where access to health care can be more difficult) we are still looking at a high cost home with a high cost property tax.
The other thought is part time living. We love New Orleans (our prior home) and I could see us living 4 months there (January through April) and 8 months in Cali. That may be the ideal set up for us in retirement. If that was the case, maybe we set up part time apartment residences in both and avoid having to own furniture or pay property taxes.
Ah the options are endless.
Just to be clear, I WISH I lived in California, but I am actually domiciled in Pennsylvania :). I will take you up on that visit to Sonoma; I ran the Healdsburg half-marathon a few years back, and we love it there.
Property taxes are interesting in California. My wife has family friends who have lived in Santa Barbara for decades, and because of prop 13 their taxes are a pittance. They have considered building an addition to their small house, but from my understanding increasing the footprint of the home would trigger a huge increase in property taxes, so they have not done it.
Some variant of snowbirding appeals to us as well. We have bandied about summers in the Pacific Northwest and winters in Hawaii, but that’s an expensive proposition. We shall see.
Thanks!
Dr. C
Great articles and subjects. Nice addition to my WCI and POF addiction! Thanks.
Thanks, ERDOC! I, too, admit a bit of an addiction to the same physician personal finance blogs, so I am glad to be named in their company.
Dr. C
Add MCL to the list of addictive substances and I’m not talking about the medical collateral ligament.
An enlightening post! I often scoff at the lists I see discussing the best states to retire to based on taxation. What taxation?
When compared to paying six-figures annually, a couple thousand one way or the other isn’t going to convince me to move to one state or avoid another. I live in a “top 3” state for high taxes as an employee, but it drops to #25 as a retiree with $70k income.
Cheers!
-PoF
If one is averse to taxes, they should move toward investment income and early retirement ASAP! I always knew taxes would be lower in retirement, I just didn’t know how MUCH lower. I suppose social security will eventually bump me into a higher tax bracket, but that’s not exactly a devastating problem.
Thanks!
Dr. C
I live in Alabama. I have thought of moving to a low or no tax state. Property Tax here is negligible. I really don’t even think about it. I have a 3200 square foot house close to my hospital and only pay $1600. My state tax bill will be about 8k this year with me working part time. I think the transaction costs of selling and then buying a new home would eat into any state tax savings for me. I do have family in Texas and the no state income tax is appealing.
It sounds like it might be wash to move and work part-time in your situation. I would have a hard time justifying a big move like that to save a few thousand in taxes; it would have to be a state in which I REALLY wanted to live.
I don’t know what your home value is, but your property tax is about 25% of mine, and I live in a 2000 square foot house. Anecdotally, it seems like many states tend to balance out property, sales, and income taxes, meaning if one is particularly high the other two are relatively low. They have to get your money somehow!
Thanks!
Dr. C
Excellent perspective! On question with respect to “no federal capital gains taxes.” If my taxable income in retirement is $70,000, my long term capital tax rate would be zero. If I netted $200,000 in a stock sale of a company I invested in two years prior to the sale, I would owe no capital gains taxes?
I’m no tax expert—I just play one on the internet—but I believe capital gains are taxed in the year they are realized. If you are married filing jointly, that would put you in the 15% LTCG bracket, but only for the gains that are more than $73,800. You would still pay 0% LTCG on the first $73,800. Again, this is my understanding, so as always talk to your tax dude.
Thanks for reading!
Dr. C
Thanks Dr Curious, sounds about right but will confirm with may accountant.
Thank you for taking the time to read and ask! An extra $200k is a good problem to have 🙂
I’ve asked that question in various blogs and you gave the most accurate and straight forward answer. Thanks..
Fascinating and useful stuff Dr. Curious!
We live in Washington state, so we typically fall in the ‘NONE’ category when it comes to state taxes, but we’re considering other states.
It would be interesting to see (alongside this data) sales tax rates on spending and property tax rates. The overall tax burden could be very different in Oregon for example, which has no sales tax.
It would be interesting, indeed, and I considered including this data initially. However, property taxes in my state and I believe many states are very local; for example, I get a bill from the county, borough, and school district, all of which follow different geographic boundaries. The total tax burden is certainly worth considering when choosing a location to set down roots. In your part of the country, I know people who live in Vancouver, WA for the absent income tax but shop across the border in Oregon for absent sales tax.
Thanks for stopping by, Mr. Tako!
Dr. C
Nice research on this topic. I always thought state tax in my bracket for early retirement would be negligible, and so it is! We have the same desired annual income btw.
I live in North Dakota, so any post you have with redwoods, warm looking weather or the word California will get my attention.
Are you geographic arbitraging or a native of ND? Either way, I will be sending some tropical vibes your way come January.
After income taxes, loan payments, (some) insurance payments, and regular retirement savings go away in retirement, it’s amazing how little one needs to easily cover expenses.
Your comments are much appreciated, as always!
Dr. C
We’ve been in the Nodak 4 years now. Originally from Louisiana and practiced there for a bit before an opportunity from a friend arose here. I guess I’m becoming a Nodak native (I now pronounce Bison with a “z” as in Bizon) but a little geographic arbitrage doesn’t hurt : )
I’ll be needing those tropical vibes in January, although Pennsylvania can get chilly too I hear. We’ll be in Kauai, maybe I’ll post on that and try my hand a travel
Blogging.
Excellent discussion of state income taxes. Thanks for highlighting that it’s more complicated than just looking at the highest marginal tax bracket.
When deciding where to retire, it is important to consider income tax, property tax, sales tax, and general cost of living. This website estimates your state income tax based upon a given income and also discusses property tax and sales tax: https://smartasset.com/taxes/alaska-tax-calculator#0YSCdWwGyj
For the time being, Alaska has no state income tax and Anchorage has no sales tax. We don’t currently own a home but according to the website, Alaska has the 19th highest Property tax rate in the nation.
Wow, that website has a lot of tax info! I know in Pennsylvania (where I live), property taxes can vary widely a few miles away. In retirement, property taxes have a good chance of being my largest tax expense. I might not exclude living somewhere due to state income tax, but I very well might be swayed by a huge property tax bill!
Thanks for reading
-Dr. C
You mentioned you’re from TN originally . As someone who has lived in California and is now in Nashville, I can attest to the difference that the lack of state income tax makes when you are your working, accumulating years. Our property taxes work out to about ~0.75% of the value of a home per year, and we didn’t even have to file a state tax return because we kept dividends under $2,500. nashville is booming- I meet more and more NY and CA transplants all the time. Will likely only increase if the State and Local Tax deduction is killed…
I’ve heard good things about Nashville. My wife has relatives who live in the area and love it there. I refuse to let the tax tail wag the dog, but I certainly wouldn’t mind a few extra $K in my pocket every year!
Thanks for stopping by,
Dr. C
It looks like the $70k/yr LTCG example gives a nice outcome in most states and maybe that works in early retirement. However, some may plan on Roth conversions before RMDs at >70.5, and taxes on such could be troublesome in high tax states. Likewise, withdrawals from traditional deferred retirement accounts will lighten the wallet at tax time. I might need to plan Roth conversions or traditional withdrawals while in a no tax state before moving to a more taxing one. In any case, the calculator reference was a good one, along with http://www.tax-rates.org/income-tax-calculator/.
Yes, and ugh—I didn’t even want to touch the Roth conversion issue. I know many try to convert when incomes are low up to the top of the 0% LTCG bracket, but I will leave a discussion of that up to the experts. I’m hoping to defer traditional retirement account withdrawals as long as possible.
Thanks for stopping by!
Dr. C
Hey there…great workup on state taxes. I came across you while wondering if anyone in this sphere had ever done (and published) what I’m working on—state taxes for early retirement scenarios. Just wanted to mention that the calculator that you used doesn’t take into account standard deductions or specific tax credits. Those will make, for example, a few hundred dollars’ difference in CA state income tax, which isn’t a big change for you at $70k, but for me at roughly half the income it makes the difference between some tax and no tax at all. For anyone interested in a lower-income compilation of tax costs, I’ll be putting my computations up at http://plottingforjailbreak.com/state-taxes/