When Congress changes federal tax law, it always dominates the headlines, but the IRS' portion of a taxpayer’s income is only part of the story. Every state has their own unique set of tax rules, and it is not enough for financial advisors to be versed in the rules of their home state.
Eight states have no individual income tax. For the other states, there are 42 different sets of rules on what type of income is taxed, how it is taxed, at what rate it is taxed and whether where you work or where you live is more important. Then one could wade into local taxes, with nearly 5,000 jurisdictions in 17 states imposing a local income tax, which can treat nonresidents differently than residents.
- Know what's out there.
- Focus on change.
- Deprioritize taxes in decision making.
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Know What's Out There
It is easy to fall into the trap of assuming that what already is known is what will continue to be encountered. Many state tax rules mirror federal tax rules, but this is far from universal. The majority of states with an income tax have a progressive system – with rates increasing as income gets higher – but there are several with a flat rate.
Rates aside, there is also an incredible variety of types of income that are taxed. The state of California is similar to the federal level in that there are few, if any, exceptions to all income being taxed in some way. On the other end of the spectrum, New Hampshire taxes only interest and dividend income.
In between those extremes are differences in tax rules on everything from Social Security and federal retirement benefits to what can be deducted and the types of credits available. Don't try to commit the rules to memory; be familiar enough that you know when more questions need to be asked. Be sure to seek out reputable sources of state tax information, such as the Federation of Tax Administrators.
Focus on Change
Quite often, meaningful tax planning comes down to making choices within the tax code. This holds true with state and local taxes as well. Particularly for taxpayers who move between states with different tax rules, there can be tremendous opportunity regardless of whether they are moving to a higher-tax state or lower-tax state, although understanding the direction is key to making the right decisions.
Consider how location impacts Roth conversion recommendations. Conventional wisdom would have advisors look for relatively low-income-tax years to intentionally accelerate income through Roth conversions: Choose to pay taxes now to avoid higher taxes in the future due to increased income, changes in tax law – or a move to a higher-tax state.
The inverse could be true if clients are considering a move to a lower-tax state. If taxpayers in New York – a relatively high-income-tax state – are considering a Roth conversion because they haven't filled up the 22% bracket, that might be the right choice in the current year if they plan to stay in state through retirement. However, if they plan to move to Florida, where there is no state income tax, in five years, they may be better off waiting to convert so they can avoid New York state income tax.
Tax planning should still be done if the opposite is true. A taxpayer living in Washington state, which doesn't tax income, who plans to move to California, which has high state taxes, to be closer to family might want to be more aggressive in making Roth conversions before the move, even if it means entering a higher federal tax bracket.
Deprioritize Taxes in Decision-Making
This recommendation may feel out of place in an article focused on tax planning, but it's essential to view tax planning as a passenger on the bus and not the driver. The question often comes from taxpayers, "Where should I live in retirement to minimize taxes?" Instead, it's important to take the full picture into account.
Great financial advisors would be wise to counsel clients to split this request into two parts. First, clients should consider where they want to live in retirement. Only once that is answered can they ask how that move should affect their tax planning. The tax burden can be vastly different depending on where a person decides to live, but saving money in taxes should not require the sacrifice of other goals. Start with family, friends, hobbies and interests when considering what state is best – and only then look at whether changes are needed for tax purposes.
The best advisors are not the ones who can recite the most lines of tax code. The key is knowing enough to be a resource to your clients. Advisors don't need to have all the answers, but a commitment to helping clients find the answers is one way to deliver massive value to them through tax planning.