State Taxes and Retirement: What You Should Know and Plan For

There are many financial challenges retirees must face. Some of these challenges include having to squeeze their nest egg to fund their retirement, having to optimize Social Security benefits, and having to make important lifestyle decisions that affect their wallets. The number of issues retirees have to deal with during their latter years seem incalculable.
This plethora of difficulties may cause important focus points such as state taxes to be swept under the rug. They should be warned: state taxes play a critical role in the quality of life of retirees. This issue must be addressed for any retiree serious about keeping costs down and enjoyment up. (For more, see: Finding a Retirement-Friendly State.)

Retirement Income Taxes

There are a number of different ways states treat pensions and retirement income. Some only tax interest and dividends, others offer specific exclusions, and still others get their money through a flat tax that applies to all residents. When it comes to pensions, there are also sometimes specific rules. In fact, the details are so unique with each state that it's best to consult a tax professional. For example, California charges 2.5% for retirees looking to withdraw from their retirement account before the age of 59½. Keep in mind that this is in addition to the federal penalty. (For more, see: 5 Tax(ing) Retirement Mistakes.)
Many retirees don't have a clue as to how retirement income is taxed and may fall into the trap of thinking that the rules are similar to other types of income — or worse, that retirement income isn't taxed at all. This is why it is critical to sit down with a tax preparer and a financial advisor to come up with a strategy for optimizing the tax efficiency of retirement accounts. (For more, see: 9 Factors That Affect When You Retire.)

Estate and Inheritance Taxes

While estate and inheritance taxes might not directly affect retirees, they do affect those whom retirees love. Heirs of an estate or those who receive an inheritance might be surprised to find that their newfound money will be taxed. Thankfully, the majority of states do not require payment of estate or inheritance taxes. However, there are still quite a few states that do. Even still, some of the states that do impose estate and inheritance taxes have large exemptions — in one case an exemption is over $2 million. Additionally, the vast majority of states do not have gift taxes. But don't forget to check at the federal level for gift taxes. (For more, see: 5 Estate Planning Tips.)

Social Security Benefits

Most states do not include Social Security benefits as taxable under their income tax rules. That's really good news, but it's important to note that the federal government may tax Social Security benefits depending on your situation. For the states that do tax Social Security benefits, the benefits are taxed to a certain extent and not necessarily exactly as the federal government does. Here again, it's important to meet with a tax preparer to discuss how this works in your state. (For more, see: Top Tips for Minimizing Taxes on Social Security.)

The Bottom Line

With a little research, some retirees may discover that moving to another state would significantly decrease their tax liability. However, retirees should consider every factor when it comes to living in a particular state so they can enjoy the retirement they've sought after — and deserve — after all those years of hard work. It is critical to consult with a tax preparer and a financial advisor to come up with a strategy. (For more, see: The Worst States for Taxes During Retirement.)