Each year Kiplinger ranks all of the states for “friendliness” of tax policy for retirees. For 2015, California finds itself ranked dead last for all states. For those of us who can’t break ourselves away from the sunshine, it becomes extremely important to be tax aware to successfully transition into retirement in the Golden State.
So how do we decide a state is unfriendly in regard to taxes? First, we have to understand how the state collects taxes.
Sales tax is a straightforward tax that is levied against all purchases you make. If you buy a $100 pair of shoes and have a 5% sales tax, you owe $5 in taxes. Typically this tax is collected by the seller and sent on to the state.
So how does California rank on sales tax? We are #1! We have the highest base sales tax at 6.5% with a mandatory additional 1% for the local municipality. At least it stops at 7.5% right? Absolutely not, the additional 1% is just a minimum. While Ventura County only uses the 1% minimum, counties like Los Angeles go ahead and tack on an additional 1.5% bringing their sales tax to a whopping 9%. Next time you are in Santa Monica, check your receipt. They add another 0.5% on top of the county and total 9.5%.
Income tax is what it sounds like: a tax on your income. Income tax is tiered and considered a more “progressive” tax. Those who are fortunate enough to make more get taxed at a higher rate. Income tax is far more complex than the sales tax and is subject to all kinds of deductions and exemptions. This tax is typically withheld by your employer.
California hosts a very progressive tax structure. While it starts low at 1%, it scales all the way up to 13.3% and, you guessed it, is the highest in the nation.
For those who own property, you too are subject to another tax. This one is based on the assessed value of your property. However, instead of going to the state, this goes to the local government. Property tax is paid directly by the homeowner but can be sometimes held in an escrow account by the mortgage company and accumulated with the monthly mortgage payment.
In California there is another 1% minimum for property taxes and, again, the keyword is minimum. Westlake Village comes in at 1.08%, Los Angeles is at 1.22%, and for those who own in Industry, an incredible 1.93%. If that wasn’t enough, for certain developments there is an extra Mello-Roos tax as a backdoor way to raise taxes higher than Prop 13 allows.
There are still other types of taxes and fees but these three categories make up the vast majority of tax collections. So how does California compare to a more tax-friendly state? Let’s use Delaware as a comparison point.
Retrieved from: http://www.kiplinger.com/tool/retirement/T055-S001-state-by-state-guide-to-taxes-on-retirees/compare.php?ids=5-8
There is no sales tax in Delaware and while their minimum income tax is higher at 2.2%, the maximum is far lower at 6.6% vs. California’s at 13.3%, but what really sets apart states like Delaware is favorable tax laws specifically targeted for retirees. They exclude the first $12,500 of investment and pension income and boost the standard deduction for those over 65. There are also tax breaks on property for seniors.
All of this combined with a substantially lower cost of living creates an advantage to living in nearly any other state in retirement. For those of us who can’t break away, what do we do to keep our taxes manageable? Unfortunately, there is not a whole lot you can do to avoid property and sales taxes besides living in a smaller home and buying less (which is an excellent retirement strategy). However, income tax is another story.
There are many ways to balance income from retirement accounts with after-tax savings to remain in lower tax brackets. Furthermore, the type of investments you place in your different types of savings accounts can also impact your taxes. Additionally, we recommend deferring social security, not only to get a larger benefit but because it is also taxed favorably versus other sources of income. Roth conversion strategies can also be a great way to reduce taxes on required minimum distributions in the future.
Taxes can make or break a retirement plan, especially in California. Tax planning can go a long way in ensuring that your funds meet all of your goals. For Kiplinger’s full ranking of state’s “tax friendly-ness,” please see the link below. For more ideas on saving on taxes feel free to check out our other articles or reach out to one of our advisors.
Rapacon, Stacy. "How Every State Ranks For Retirement." (April 24, 2015). http://www.kiplinger.com/article/retirement/T037-C000-S001-how-every-state-ranks-for-retirement-2015.html