Submitted by Arthur J. Dykes, CPA, and Donald Paris, CPA

We mostly realize that our Federal taxation system is complex, in a constant state of change, and requires more specialists than the leading U.S. hospital to administer. But are you aware that the 50 states are getting to be in a similar situation?

Consider Mr. and Mrs. Jones, both in their early 60’s and considering the issue of retirement, and where to retire, and how their retirement funds will be taxed. They owned a small business with sales in multiple states or over a website. They had no idea of the state tax complexities affecting their decision on where and how to file state taxes?

People planning to retire may use the absence of a state income tax as a barometer for a retirement living destination. Yet, the lack of a state income tax does not ensure an overall low state tax burden. Higher real estate, sales, fuel, and other taxes must be considered, as many states are currently using these taxes and fees to shrink expanding state budget deficits. Your business may be subject to all of these taxes if you conduct business in the state, which generally requires property or employees located in that state. (Referred to as having nexus in that state).

It is estimated by the Tax Foundation that you can expect to pay almost 10% of your income to pay for state and local taxes. New Jersey residents have the dubious record of being the highest tax state, followed by New York and Connecticut. Maryland ranked 4th while Virginia was 18th and the District of Columbia came in 8th.

Retirees need to consider how their pensions will be taxed:

  • Under federal law, a taxpayer may be required to include a portion of his or her Social Security benefits in their taxable adjusted gross income (AGI). Most states begin the calculation of state personal income tax liability with federal AGI, or federal taxable income. In those states, the portion of Social Security benefits subject to personal income tax is subject to state personal income tax unless state law allows taxpayers to subtract the federally taxed portion of their benefits from their federal AGI in the computation of their state AGI.
  • Many states exclude Social Security retirement benefits from state income taxes. The District of Columbia and 27 states with income taxes provide a full exclusion for Social Security benefits -- Alabama, Arizona, Arkansas, California, Delaware, Georgia, Hawaii, Idaho, Illinois, Indiana, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Michigan, Mississippi, New Jersey, New York, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, South Carolina, Virginia, and Wisconsin.
  • States are generally prohibited from taxing benefits of U.S. military retirees if they exempt the pensions of state and local government retirees. Most states that impose an income tax exempt at least part of pension income. Different types of pension income (private, military, federal civil service, and state or local government) are often treated differently for tax purposes.
  • California, Connecticut, Nebraska, Rhode Island, and Vermont do not provide any exemptions or tax credits for pension and other retirement income that is included for federal purposes. Most in state government pensions are taxed the same as out-of-state government pensions. However, Arizona, Idaho, Kansas, Louisiana, New York, and Oklahoma provide greater tax relief for in-state pension plans than they do for out-of-state government pension plans. The District of Columbia also provides greater tax relief for DC government pensions than for state government pensions.
  • For retired military, some states provide special tax benefits, while other states follow the federal rules.

If you are considering moving to change your state residency to a state with lower taxes or perhaps no income tax, beware of all the tax issues and not just how your retirement pay will be treated.

As a result, it is very important to avoid missteps in establishing your state domicile. While the safest course of action is to sell your property in the former state, it is certainly all right to hold on to it if other essentials have changed. If your residency change is questioned, the determination will be a test of facts and circumstances.

Therefore, relocating ones’ state tax domicile must be a bona-fide event. Your commitment to actually spending time in your new location is a very important factor.

For example, if you travel three months out of the year, that leaves nine months of "residency." Of those nine months, the majority should be spent in the new state. If you travel more frequently and spend little time in either your new or prior state of residency, you may face difficulties proving that you have changed your residence. Consequently, you need to pay careful attention to all the personal details that support your new residency states (i.e. number of days in state, vehicle registrations, voting registrations, mail delivery, address on tax returns, etc.).

Because state budget deficits are increasing, state taxing authorities are very sensitive to these issues. Accordingly, each state taxing authority makes nexus and domicile and residency determinations on their own, and it is possible that each state’s interpretation of where you live or conduct business, may conflict. In either case, you have the burden of proof to show why you believe you have moved for state tax reasons, or have no nexus in that state.

In all cases, seeking advice from a specialist in state and local taxation is the prudent way to go.