It’s Not As Easy As You Think!
Often, wealthy older clients from high tax states will consider moving to a lower taxed state to save taxes. This typically involve state income taxes on retirement benefits and state estate taxes on their net worth /gross estates. You may have heard people say “If I live for more than 180 days in a particular state, then I will have successfully changed my residence for state tax purposes.” This statement has a small degree of truth to it, but it’s short-sighted and far from accurate.
First, let’s have a brief discussion about state income taxes on retirement benefits. Then, let’s talk about state estate taxes on a gross estate. Finally, we’ll explore the many hurdles to overcome when thinking about changing your legal residence.
State Income Taxes on Retirement Benefits
Prior to 1996, certain states would aggressively seek out former residents to try to tax their retirement income benefits in the state where the individual lived during their working career. In 1996, this state practice was dealt a significant roadblock with the passage of “source tax” relief by the U.S. Congress which was signed into law by President Clinton.
This federal law (Title 4 United States Code (USC), Chapter 4, Section 114) prevents states from taxing former residents on all distributions received from any qualified retirement plans after they become legal residents of another state. Of course, the key phrase in “legal resident.” It makes no difference if the distribution is in a lump sum or a series of payments over the life of the participant. Only the state of legal residence will be able to levy state income tax, if any, on qualified plan distributions.
Prior to passage of this anti-source tax law, certain states such as New York and California imposed income taxes on qualified plan benefits based on a “source” theory of taxation. For example, someone might spend their working life in New York (high personal income tax rate) and retire to Florida (no personal income tax). Or someone might have worked in California (high personal income tax rate) and retired to Nevada (no personal income tax).
In fact, New York, California, and other high income tax states had carried out an active campaign to tax qualified plan benefits when received by former residents. The tax collection tactics of these high tax “source” theory states was rendered illegal by Title 4 USC, Chapter 4, Section 114. This Federal law prohibits states from taxing non-residents on qualified plan income.
Qualified retirement income is defined as distributions from employer provided pension plans under IRC Section 401 (Defined Benefit, Profit Sharing, 401(k)), Simplified Employee Pensions (SEP) under IRC Section 408(k), Tax Sheltered Annuities under IRC Section 403(b), IRAs under IRC Section 408, and IRC Section 457(b) “eligible” plans for non-profit or government employees.
In summary, the key question is “Did the individual actually become a legal resident of the new state”? We’ll explore some of the requirements to become a legal resident shortly.
State Estate Taxes at Death
The second major state tax that may impact certain individuals is found in those states that levy state estate taxes at the death of a legal resident. About 20 states currently tax the gross estate of an individual at death. Many of these states are found in the Northeastern part of the U.S. Generally, the tax rates progressively range from about 6% to 16% with a variety of state exemptions.
For instance, a taxable estate of $2,000,000 would generate a state estate tax of about $100,000; a taxable estate of $5,000,000 would generate a tax of about $400,000; a taxable estate of $10,000,000 would have a tax of just over $1,000,000; and a taxable estate of $20,000,000 would have a tax of over $2,600,000. For estates over $10,000,000, the maximum rate on the excess ranges from 12% to 16% depending on the state. There is a federal estate tax deduction for any state estate taxes actually paid. Again, the state of legal residency is the key question to determine whether an individual will be subject to state estate taxes.
2015 Summary of Selected States and Corresponding Exemption and Maximum Tax Rates
- •Massachusetts – $1,000,000 exemption and maximum estate tax rate of 16%
- •Rhode Island – $1,500,000 exemption and maximum estate tax rate of 16%
- •Maine– $2,000,000 exemption and maximum estate tax rate of 12%
- •New York – $3,125,000 exemption and maximum estate tax rate of 16% (Note #1)
- •Vermont – $2,750,000 exemption and maximum estate tax rate of 16%
- •Connecticut – $2,000,000 exemption and maximum estate tax rate of 12%
- •Maryland – $1,500,000 exemption and maximum estate tax rate of 16% (Note #1)
- •New Jersey – $675,000 exemption and maximum estate tax rate of 16%
- •Pennsylvania – No exemption and a maximum inheritance tax rate of 4.5% (children)
- •South Carolina – has no state estate tax
- •Florida – has no state estate tax
- •Virginia – has n0 state estate tax
- •New Hampshire – has no state estate tax
- •California – has no state estate tax (CA has high state income taxes)
- •Texas – has no state estate tax
Based on state income taxes and state estate taxes alone, certain individuals and couples often decide that it would be in their best interest to permanently move to a state with lower taxation. States that have both no income taxes on retirement benefits and no estate taxes would be particularly favored as choices for permanent residency (i.e. Florida, Texas, Nevada, New Hampshire, Alaska, South Dakota, and Wyoming).
Note #1: New York and Maryland are in the process of phasing in an increase in their state death tax exemptions over the next few years. Eventually, the New York and Maryland exemptions will be equal to the federal estate tax exemption by 2019.
Note #2: Keep in mind that real estate owned in the former state will still be subject to state estate taxes in that state at death. Rental income and capital gains upon any subsequent sale of the property will be subject to income and capital gains taxes in that former state as well.
General Requirements to Legally Change State of Residency
Now that we have summarized state income taxes on retirement benefits and state estate taxes at death, let’s take a look at the question of how to determine that an individual has actually become a “legal” resident of a new state. If you have not become a “legal” resident of a new state, then the former state would still have the possibility of taxing retirement benefits during lifetime and levying estate taxes at death.
Changing residency is not as easy as you may think. Many states impose a subjective test that looks at an individual’s connections to each state to determine residency. What are some of the steps that must be taken to sever ties with the old state and establish strong connections with the new state to document a change of residency?
Many states determine tax residency by looking at a person’s domicile or place where the individual has the closest connections. As a subjective test, state courts and tax authorities will consider many factors to determine residency for tax purposes. Here is a list of some of those important factors:
- •The location of the individual’s principal residence and whether the residence is owned or rented. If an individual has more than one residence, the courts and tax authorities will look at where the individual keeps personal belonging, lives with family, and intends to live indefinitely
- •Time spent in the new state versus the old state
- •Location of the individual’s spouse and children
- •The state in which the individual’s car is registered
- •The state issuing the individual’s driver’s license
- •Where the individual is registered to vote
- •The location of the individual’s bank accounts.
- •The location of the individual’s brokerage accounts and the origination point of the individual’s financial transactions
- •The location of health care providers like doctors and dentists
- •The location of accountants and attorneys
- •Location of a place of worship or social and country clubs of which the individual is a member
- •The location of real estate
- •Address listed on Form 1040 U.S. Income Tax return
- •The location of any safe deposit boxes
- •Where estate planning documents have been executed (i.e. wills, revocable trust, durable powers of attorney)
Generally, the facts and circumstances based on the list above will determine in which state the individual is most closely associated. It is the strength of those connections created in the new state which will ultimately determine residency for state tax purposes.
Your clients who are considering moving to a new state should have a plan of action to sever connections with the old state. A successful change of residency can save hundreds of thousands or even millions of dollars of combined state income taxes and state death taxes.
Keep in mind that no matter in which state your client is seeking to establish residency for state tax purposes, federal income taxes will still be due and payable on their retirement benefits. And gross estates in excess of the federal exemption amount will still have federal estate taxes due and payable no matter where their assets and property are located in the U.S.
Contact BSMG Advanced Sales if you need a state by state reference for state income taxes and state estate taxes. Your client’s estate planning attorney and tax advisors will play a critical role in advising your clients who are considering a permanent change of residency.
Russell E. Towers JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group