Relocation May Cut the Tax on IRA Distributions

 In Taxes

Residents of high tax states and cities know that taxes don’t begin and end with the IRS. You might be in a 25% or 28% federal income tax bracket, yet each dollar you earn could be taxed at 30 to 35 cents or more after paying state and local income tax, as well as federal income tax.
Taxpayers in high tax jurisdictions have a mixed blessing, however. Their steep tax rates increase the value of tax deductions, including contributions to retirement plans. What’s more, a move to a low tax area in retirement can increase the effective benefit from those plans.
Example: Frank Richards lived in a high tax area when he made most of his retirement plan contributions. His effective tax rate in many of those years was 45%, counting federal, state, and local taxes. Frank now has $600,000 in his IRA, all from pretax contributions.
Frank is considering two options now:
He can convert all or part of this traditional IRA to a Roth IRA, from which he can take tax-free distributions after five years and after age 59½.
Frank will owe income tax on the amount of money he converts.
2. He can leave all the money in his traditional IRA. All distributions will be fully taxable. Even if Frank does not need money, he must take required minimum distributions after age 70½ and pay tax on those distributions.
If Frank stays in his high tax area, he will owe applicable federal, state, and local income tax on Roth IRA conversions and traditional IRA distributions.
Smart move
Alternatively, Frank can move to a low tax state or even a state with no income tax. (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming have no personal income tax, and New Hampshire and Tennessee only tax interest and dividends.) Subsequently, he would owe little or no state tax on IRA conversions and distributions. In addition to Frank’s retirement plan contributions saving him 45 cents on the dollar, in this example, he also might only pay federal income tax of 25 or 28 cents on the dollar on withdrawals.
As you can see, high tax states are losers in this type of relocation. If you worked in California while you built up your retirement fund with pretax contributions, you paid less tax to California. But California will receive no makeup income if you move to Nevada before taking IRA distributions.
Federal law prevents states from taxing IRA or pension distributions paid to a former resident who is now living in another state. However, that law does not prevent states from continuing to claim you as a resident and demanding tax on your retirement plan distributions if your accounts and holdings remain active in that state. Therefore, if you want to avoid paying tax to your former state, you should sever all ties. Sell your home in the old state, close bank accounts there, file federal tax returns with your address in the new state, and so on. Often, states with high income taxes have high estate taxes, as well, so thoroughly changing your state of residence may pay off for you during your lifetime and also may benefit your beneficiaries after your death.