How Do State Taxes Affect Retirement Planning? — Oblivious Investor

A reader writes in, asking:

“Would it be possible for you to write an article on how to best account for state income taxes when planning as a retiree or near-retiree?”

It’s obviously challenging to write any sort of catch-all article about state taxation, because the rules vary from one state to another. But the following are the primary questions that I start with when doing a retirement/tax plan. (Of course, the answers to these questions sometimes bring up other questions.)

• What are the state’s rules regarding taxation of Social Security benefits?
• What are the state’s rules regarding distributions from traditional IRAs?
• What are the state’s rules regarding distributions from tax-deferred employer plan accounts such as a 401(k)?
• Does the state have an estate (or inheritance) tax? If so, what is the threshold, how is the taxable estate calculated, and what are the tax rates?

A relevant point is that these rules do change from time to time. So be skeptical about the websites that purport to tell you about all 50 states, as there’s a meaningful chance that that information is out of date, given how hard it is to keep something updated for so many states. (Plus there’s the chance that any general-audience media publication will simply get something wrong or leave out important facts.)

If at all possible, it’s best to find the applicable information on the website of your state’s department of revenue.

Tax Treatment of Social Security and Retirement Accounts

There are many states in which Social Security benefits are not taxed, yet distributions from tax-deferred accounts are taxed. When this is the case, it’s a point in favor of spending down tax-deferred accounts in order to delay Social Security. Reason being, when you spend down tax-deferred accounts earlier, you’re giving up future gains in those accounts. And those additional tax-deferred dollars that you’re giving up would have been fully taxable, whereas the additional Social Security dollars that you’re getting in exchange will not be taxable.

And then there are cases where particular states have very specific rules that create planning opportunities.

For example, Connecticut gives better tax treatment to distributions from 401(k) or similar plans than it does to distributions from traditional IRAs (at least for now), which is a point in favor of rolling IRA assets into a 401(k) just to take advantage of that better tax treatment.

Colorado has an annual “pension or annuity deduction” for people age 55 and up, which allows you to deduct annuity income, pension income, Social Security income, or tax-deferred distributions that were taxable at the federal level. However, there is an annual limit based on your age ($20,000/person if age 55-64, or $24,000/person if age 65+). One exception to the limit is that if your Social Security benefits exceed the limit, all of your Social Security benefits will be excluded from your Colorado taxable income. How this affects planning is that a) it’s another point in favor of delaying Social Security and b) you don’t want to go under the limit in some years and then way beyond it in other years. (You can use Roth conversions to take up any space in a given year that would otherwise be unused.)

These are just the sorts of things where you have to take the time to learn the rules in your state and think through what the ramifications might be.

State Estate Taxes

The federal estate tax only affects a very small percentage of households these days, with its $12,060,000 exemption as of 2022 (and double that for a married couple).

But there are some states that have their own estate tax, and in some cases the exemption amount is much lower. For example, Oregon’s estate tax applies to the amount by which an estate exceeds $1,000,000. In Massachusetts, any estate over $1,000,000 has to pay estate tax, and it has to pay the tax on nearly the whole amount, not just the amount by which the estate exceeds the threshold. Washington state has an estate tax for estates over $2,193,000.

Again, it’s best to just take the time to look up the rules specific to your state.

If your state has such a tax, depending on the threshold amount, the accompanying rules, and your projected assets, there could be lots of planning implications. It might be a big point in favor of gifting/donating during your lifetime. It might be a point in favor of creating certain types of trusts. It’s often a point in favor of Roth conversions, because when you do a conversion, the size of the taxable estate is reduced. (For example, after a given year’s conversion you may be left with $80,000 in a Roth IRA rather than $100,000 in a traditional IRA, which is a good thing as far as estate tax goes.)