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?
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.
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.
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!