Save on State Taxes by Splitting Retirement Income

Save on State Taxes by Splitting Retirement Income

Smart retirement planning includes taking advantage of a maze of complex – but ultimately favorable – state tax policies. Almost every state has its own policies when it comes to retirement income. By understanding these policies and implementing tax-smart strategies, you can significantly reduce retirees’ annual state tax bills.

Many states treat retirement income differently than other income and exclude some level of Social Security and/or pension income1 from taxation.2 These exclusions, along with a range of other tax policies that have a direct impact on retirees, can make even supposedly high-tax states like California and Hawaii into low- or zero-tax states. But in the following thirteen states, getting the most from these tax exclusions requires careful planning both before and during retirement.

(For a more thorough guide to state income taxes in retirement, see our State Income Tax Guide.)

Splitting Taxable Retirement Income Between Spouses

The states included in the list above apply retirement income exemptions on a per-spouse basis, not as a combined exemption for the household. This means that in order to access up to double the per-person exclusion each spouse needs to have their own retirement income. For example, in Georgia, spouses who are both age 65+ could exclude a combined $130,000 in retirement income. However, each spouse can only exclude up to $65,000 of their own retirement income.  If one spouse has, for example, $140,000 in income and the other spouse has none, only $65,000 could be excluded from state taxation.

 

Scenario 1A – Exclusion Not Maximized

Scenario 1B – Exclusion Maximized

Social Security Matters

In Colorado, Maryland and Maine, Social Security income reduces otherwise available retirement income exclusions. Of course, it is generally not feasible to plan proactively for a couple to qualify for similar Social Security benefits and therefore “split” Social Security income evenly between spouses). But it is still important to adjust distributions in these states to maximize total exclusions. This may be especially true during years when one spouse takes Social Security and the other does not, or if one spouse’s Social Security income is substantially lower than the other’s. In such years, it may make sense for the spouse with lower Social Security income to take more in qualified plan distributions. Taking this action can even out total retirement income between the spouses up to the exclusion amount available in their state.

For example, imagine Jim and Jill live in Colorado. Jim is 67 and receives $36,000/year in Social Security while his wife Jill is 62 and is planning to delay taking Social Security until age 70. If the couple wants a total of $60,000 in pre-tax income, it may make sense to have Jill take $24,000 from her qualified plans, since this would maximize their Colorado tax exclusions and result in $12,000 in Colorado-taxable income for the couple. If instead Jim took $24,000 from his own qualified accounts, the couple would have $36,000 in income taxable at the state level.

 

Scenario 2A – Exclusion Not Maximized

Scenario 2B – Exclusion Maximized

Other Considerations

Of course, as with so many planning strategies, other considerations may outweigh this state tax strategy. For example, income splitting could be less attractive if one spouse has particularly large qualified accounts. Large qualified balances could result in high required minimum distributions later in life, which could push the couple into very high tax brackets. In this case, it may make more sense to take distributions in early years when they can be taxed at lower rates, even if these distributions would also be taxable at the state level.

 

State-by-State Guide

The details of retirement income exclusions can be quite complex. Here we detail some of the rules that apply in these “income splitting” states.

 

  • Arkansas: Up to $6,000/person in taxable pension and qualified plan income is excluded from taxation. Military retirement income is also excluded from taxation, but taxpayers cannot both exclude military retirement income and claim the $6,000 pension exclusion. Pension/IRA distributions for reasons other than retirement, death, or disability (e.g., for medical expenses, higher education, or a first-time home purchase) do not qualify for the exclusion. Lump-sum distributions are not eligible.
  • Colorado: Exclude from state taxation up to $24,000/person (age 65+) or $20,000/person (age 55-64) any Federally taxable Social Security income and taxable pension/qualified plan income received for retirement, death or disability. (No separate exclusion of Social Security income is available in Colorado.) Amounts subject to pre-mature withdrawal penalties cannot be excluded. Lump-sum distributions are not eligible.
  • Delaware: Exclude from state taxation pension and retirement income up to $12,500/person age 60+ or $2,000/person under age 60. Amounts subject to an early withdrawal penalty or amounts received due to death are not excludable. Income from a maximum of one defined benefit pension can be excluded per person, along with other eligible retirement income. Eligible retirement income includes taxable distributions from IRAs and qualified plans as well as rental income and taxable dividends, capital gains, and interest from investments not held in retirement accounts.
  • Georgia: Allows exclusion of “retirement income” up to $35,000/person age 62-64 or $65,000/person age 65+. Retirement income includes up to $4,000/person of earned income and most other kinds of income (pensions, qualified plans, non-qualified investment income, rental income, etc.).
  • Kentucky: Exclude up to $31,110/person in pension and qualified retirement plan income.
  • Maryland: Exclude up to $31,000/person in pension and qualified retirement plan income. Maryland also excludes Social Security income from taxation. However, the $31,000/person retirement income exclusion is reduced dollar-for-dollar by an individual’s total Social Security income, whether or not it is taxable at the Federal level. Therefore, if a taxpayer has $31,000 or more in Social Security income, no additional exclusions are available.
  • Maine: Exclude up to $10,000 per person in pension and qualified retirement plan income. Maine also excludes Social Security income from taxation. However, the $10,000/person retirement income exclusion is reduced dollar-for-dollar by an individual’s total Social Security income, whether or not it is taxable at the Federal level. Therefore, if a taxpayer has $10,000 or more in Social Security income, no additional exclusions are available.
  • Missouri: Different exclusion rules apply to public pension income (generally, pensions from government sources) and private pension income. For private pension and retirement plan income, up to $6,000/person can be excluded, but this exclusion is reduced at certain income thresholds.
  • Montana: Exclude up to $4,300/person in pension and retirement plan income. This exclusion amount is reduced or eliminated above certain income thresholds.
  • New York: Exclude up to $20,000/person age 59½+ in pension and taxable retirement plan income.
  • Oklahoma: Exclude up to $10,000/person in pension and taxable retirement plan income.
  • Rhode Island: Up to $15,000/person in pension and retirement plan income can be excluded by individuals of full retirement age. This exclusion is subject to phase-out above certain income thresholds. IRA distributions are not eligible for this exclusion.
  • South Carolina: Up to $3,000/person under age 65 or $10,000/person age 65+ of qualified plan income can be excluded. Amounts subject to an early withdrawal penalty are not eligible for this exclusion.

1 Though state rules differ slightly, pension income typically includes funds withdrawn from IRAs, retirement plans like 401(k)s and 403(b)s as well as defined benefit plan income.

2 All tax commentary is intended for general education. For information on your situation, please consult a tax professional. All information discussed here is based on the 2019 tax year. State tax policies are subject to change.

 

Annual Guide to State Taxes in Retirement

Annual Guide to State Taxes in Retirement

 

There is never a bad time to start planning for tax season, which is why now is a good time to read our Guide on State Taxes in Retirement. The Guide provides retirees tips and tricks for reducing their annual state tax bills. Turns out every state is different and knowing your state’s policies can save you a lot of money.

Read More >>

In Retirement, Your State Tax Bill Could be Zero

In Retirement, Your State Tax Bill Could be Zero

If you search for information on state personal income taxes, you’ll likely find a list that focuses on the highest marginal rate in each state, with states like California, Hawaii and Oregon topping the list of high-tax states. But for retirees, focusing on tax brackets alone (especially the top tax bracket!) can be downright misleading. A range of tax policies related to age and income type can make even a supposedly “high tax” state like California into a low- or zero-tax state for many retirees. So, when it comes to evaluating states for their tax-friendliness to retirees, we need to look deeper.

“Zero-Tax” States

Seven states have zero personal income tax at the state level. Another two states tax only certain types of investment income (like interest and dividends) but not other income (like wages and pensions). Clearly, all else being equal, these states are the most tax-friendly to all taxpayers, retirees included.

  • States with no personal income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming
  • States where only certain investment income is taxed: New Hampshire, Tennessee

But, for retirees, the list of states that offer the chances of zero state income taxation (or at least taxation that is far below what you would pay in your working years) is much longer. Depending on the make-up of your retirement income picture, you might be looking at low or no state income tax in retirement even if you don’t live in the above nine tax havens.

For example, 29 states and the District of Columbia exclude all Social Security income from taxation. Three states on this list – Hawaii, Illinois, and Pennsylvania – also exclude pension and qualified retirement plan income. Fifteen states include some level of capped exclusions for pension and other retirement income, from a low of $4030 per spouse (Montana) to a high of $65,000 per spouse (Georgia). Twenty-four states also offer additional deductions, exemptions or credits to people age 65+, leading to even lower taxes for many retirees. 1

California as a Low-Tax State?

In order to explore what the state tax landscape looks like for retirees, we estimated the 2019 state personal income tax burden of the following two households in all 50 states and the District of Columbia. 2

Household A

For Household A, the results of this test may be surprising. For this family, in addition to the nine no-tax or investment-income-tax-only states, 14 states had an estimated $0 state tax bill. On this list are California, Hawaii and New York, three of the states commonly thought of as high-tax states.

Additional States with a $0 tax bill for Household A

In another eleven locations (AZ, CT, DC, IA, ID, ND, NE, NJ, OH, OK, VT), this family’s effective rate would have been below 1%. (And in Oklahoma they would have paid just $33, or 0.04% in taxes.)

The states where this family would have paid the highest tax were Utah (3.6% effective rate) and West Virginia (3.1% effective rate) – neither of which is commonly highlighted as a high-tax state.

Household B

Because of its higher total income and its investment income, the number of zero-state-tax states for Household B is smaller: we estimate zero state taxes in the seven zero-tax states and Georgia. But this family’s tax burden in many states is still lower than one might expect. Fifteen states had effective rates below 2%. On this list, we once again find California and New York.

States with a less-than-2% effective tax rate for Household B

Retiree-Friendly States

The tax burden in any given state will depend on a family’s total tax picture. But these two example households show that some states with high top marginal rates can actually be quite tax-friendly to retirees. Some states, like Georgia, Hawaii, Illinois and Pennsylvania, often masquerade as zero-tax states for some retirees. Typically, the more a household depends on Social Security and qualified retirement plans and pensions, the higher the likelihood that they will come close to paying no state income tax.

More Information

Decisions about where to live in retirement go far beyond financial considerations. But it is important to have the right facts when evaluating how tax-friendly your state of residence in retirement might be. To help us move beyond a simplistic and misleading focus on top marginal tax brackets and into the true possible state tax experiences of retirees, Income Lab has released a useful Guide to State Personal Income Tax for Retirees that provides commentary and information on all 50 states and the District of Columbia.

1 In some states, these capped retirement income exclusions and age-based deductions, exemption and credits may be subject to income-based phase-outs.

2 We assumed that Social Security and Pension/Qualified Plan Income was evenly divided between spouses.

A Stock Indicator that can Improve Retirement Income Decisions

A Stock Indicator that can Improve Retirement Income Decisions

In times of economic turmoil, it’s helpful to know that there is a long-term stock market indicator that can help us make better retirement income decisions. Numerous economic factors can inform retirement income decisions, but none has been discussed more than the cyclically-adjusted price-earnings ratio (CAPE), a long-term measure of how much investors are willing to pay for corporate earnings.1 This ratio plummeted during the recent stock market drawdown. But historical evidence shows that as CAPE goes down the percentage that a retiree has been able to withdraw from his or her portfolio has gone up. Let’s review this evidence and see what it may mean for today’s retirement investors.

CAPE’s Historical Relationship to Retirement Income

Retirement is a long-term event. CAPE is a long-term indicator. So, it’s not surprising that CAPE has a lot to say about retirement income. The box plot in Figure 1 shows the historical distribution of available 20-year portfolio withdrawal percentages,2 grouped by initial CAPE value, since 1881. (The “boxes” show the middle 50% of data. The “whiskers” show the lowest and highest 25%.)

Figure 1

CAPE levels (divided into historical quintiles): Low – CAPE between 4.6 and 11.2; Below Average – 11.2 to 14.8; Average – 14.8 to 17.8; Above Average – 17.8 to 22.2; High – 22.2 to 44.8.

The high-level pattern is clear. When CAPE was low, available withdrawal percentages were high. When CAPE was high, much lower withdrawal rates were possible. The same is true for 30-year withdrawal periods.4

CAPE’s Historical Relationship to Retirement Nest Eggs

This pattern might tempt us to think that high CAPEs are bad for retirement income. But the story isn’t quite that simple. When CAPE is high, portfolio balances tend to be high as well. And we don’t spend percentages – we spend dollars. The average available withdrawal rate in high-CAPE periods was 43% lower than in low-CAPE times. But those high-CAPE periods were at the tail end of some of the best stock markets in history. Figure 2 shows how much money a hypothetical retiree would have had at retirement (in 2020 dollars) if, prior to retirement, they had saved $1000/month for 30 years in a 60/40 portfolio.

Figure 2

The lesson is that high CAPEs are also high points for retirement nest eggs. The best time in history to retire wasn’t a point when the highest withdrawal rate was possible, but a time when a healthy withdrawal rate could have been applied to a large portfolio.

CAPE and Retirement Income Risk

Figure 1 holds a few more lessons for retirement income planning. For example, it suggests that the predictive power of CAPE is highest when CAPE is high. The range of withdrawal percentages available during periods of high CAPE is the smallest of any CAPE regime. This is true for both the total range (from the minimum to the maximum, between the ends of the “whiskers”) and for the middle 50% (the box, called the interquartile range).

Importantly, the lower tail of the withdrawal distribution (the lower whisker, which is the range from the lowest available withdrawal rate to the 25th percentile) and the range from the median to the 25th percentile (the bottom half of the box) are also smallest in high-CAPE periods. This means that the risk of severely overestimating available retirement withdrawals has been lowest when CAPE was highest. Overestimating sustainable withdrawal rates is the primary risk that can lead to unwanted downward income adjustments in retirement, so it is comforting to know that this risk is lowest when CAPE is highest.

High-CAPE periods are on the other extreme. The range between the lowest and highest withdrawal rates in low-CAPE periods is massive. Thankfully, rates were also substantially higher than they were in other CAPE regimes: the lowest withdrawal rate in history during a low-CAPE period was roughly equal to the average rate in high-CAPE periods, and two-thirds of the available withdrawal range in low-CAPE times lies above the highest high-CAPE withdrawal rate. So, high CAPE means high withdrawals rates but also higher risk of overestimating available withdrawals.

What’s CAPE Been Up to Lately?

Now that we know a bit about historical patterns, let’s look at how CAPE has behaved recently. Since 1881, average (median) CAPE is 16.3. But in the last 30 years CAPE has been consistently higher, with an average of 26.0. The February-March 2020 stock market drawdown brought about the largest drop in CAPE since the Great Recession.

Figure 3

Viewed across 140 years of history, the March 2020 low point is still an “above average” CAPE. However, we hadn’t seen CAPE this low since 2012, during the long recovery from the Great Recession. And this reduced CAPE value was just above the lowest levels we saw in the worst of the protracted Tech Bubble crash (2000-2003).5

The economic repercussions of the COVID-19 pandemic are still developing, so only with hindsight will we know whether this was the low point for CAPE in this market cycle. But we do know that in the past, as CAPE goes down, the pain retirees may have felt in their investment portfolio has been eased somewhat by an increase in the withdrawal percentage they could afford to take from those portfolios. We also know that, no matter the CAPE value, CAPE can help us make better retirement income decisions.

1 Traditional P/E ratios divide price by recently reported or projected earnings. But these earnings numbers are volatile, and the resulting measure isn’t very good at helping us develop expectations about future returns. CAPE, on the other hand, uses long-term (usually 10-year) average inflation-adjusted earnings and is much more useful for developing long-term expectations.

2 These withdrawal levels estimate how much of an initial portfolio balance a retiree could have withdrawn annually from a 60/40 stock/bond portfolio, with adjustments for inflation thereafter, for 20 years. Research suggests that a static approach to retirement income produces poor outcomes, but this approach is useful for comparing possible retirement income levels across historical periods. Past performance does not guarantee future results. Results based on index returns. The returns of actual investments may be higher or lower than index returns. Results would differ based on different investment mixes and retirement income plans.

3 There are many potential confounding factors when trying to interpret CAPE data. For example, accounting rules for earnings calculations have changed over time, meaning the denominator for the CAPE ratio is not consistent at all points of history. Changes in dividend/share buyback behavior and the supply of and demand for stocks may also have affected the expected numerator of the ratio over time.

4 It is common in retirement research to focus on 30-year retirement periods. We focus on 20-year periods in Figure 1 in order to increase the number of periods in our data set that represent high CAPE values. (Many of these high-CAPE periods have occurred recently, making them out-of-sample when looking at 30-year retirement periods.)

5 As of this writing (April 17, 2020) CAPE had recovered to 27.4, just above the 30-year average, but stock markets remained volatile.