I love taxes!
Okay, maybe not, but not everyone despises taxes. Yes we all want the government to spend the money wisely, but they’re a necessary evil. Many people like to complain that the government is taking “their” money. In reality salaries are determined with the expectation that you’ll be paying taxes. If you didn’t pay taxes, they would probably just pay you less.
Does avoiding state taxes pay off?
Some people flock to states that don’t have income tax. In reality they may end up not saving as much as they think, if anything at all. All the states still have the same primary expenses, so they have to make the money somewhere. It could be from higher property taxes, sales taxes, etc. That can negate any income tax savings.
While you’re in the accumulation phase of your life (i.e., earning wages), it might actually make more sense to live in a high tax state. Sounds crazy? Well, consider the average income in California is $33,719 vs. $29,159 in Florida. The current tax rate for that level of income in California is 12% for a single person, so you would take home $29,673, almost $500/year more than in Florida. You can find the average post-tax income for each state here to see for yourself.
Now, there are a lot more factors to consider. For one, the overall cost of living. Some things that often get overlooked are how your annual real income is used in determining your social security income later in life and how easy it is for you to fund your IRA/401k, up to the limit. If your pre-tax income is higher and you can more easily divert some of that to your retirement plan, you could make out better.
UPDATE: After writing this post, we happened to find another article discussing a very similar topic, but primarily contrasting the tax burden differences between Texas and California.
As an example, if you make $100K in California and contribute up to the max in 401k contributions ($20,500 for 2022), your take home pay would be $57,904, but in Florida you’d only make an equivalent $88K per year and your take home would be $50,529.
When it comes to your “spending” phase, it’s different and you obviously want to avoid as much taxes as legally possible, as well as managing expenses.
An example strategy
While we’re certainly not tax professionals, here’s one strategy to legally delay and/or limit paying taxes.
Due to depreciation, most of your income from directly held real estate will be deferred until you sell the property. Hold it forever and you’ll never pay taxes.
If qualified dividends were your only income you could earn about $50K/year and pay no taxes at all on them. You can play around with your own calculations here: http://www.moneychimp.com/features/tax_calculator.htm
The interest payments on municipal bonds are also generally exempt from federal taxes and state taxes if they are issued by your home state, so you could add additional income from these as well.
If you have a large retirement fund, this could add up to a lot of tax free / deferred income. Let’s say you “only” had a million dollars though for example.
Example allocation:
Buy a $500K rental with $2500 net monthly rent after expenses
Invest $250k in an ETF paying 2% in qualified dividends per year
Invest $250k in a municipal bond ETF at 3% in interest
You get $2500(12)+$5,000+$7,500 for a total of $42,500 all tax free. Not necessarily a fortune, but above the average US income and equivalent to a pre-tax payroll income of about $55,000.
If you’re an older retiree, you can add in social security, although that has tax implications too and chances are that you will have already paid off your home, so $42.5K post tax should stretch pretty far.
Summary
While this obviously isn’t the only strategy, it shows that with careful planning, you can meet your retirement needs without having to pay the government anything at all.