Read The Transcript:

Steven Jarvis: Hello, everyone, and welcome to the next episode of the Retirement Tax Services Podcast, Financial Professional’s Edition. I am your host, Steven Jarvis, CPA, and in this show, I teach financial professionals how to deliver massive value through tax planning. We’re going to continue this week sharing experiences, tales from tax season, some of the insight and things I learned as working with tax payers and collaborating with advisors this last tax season, wrapping up the 2021 tax year.

Today, I specifically want to talk about some fun, we’ll use that term loosely, but fun with state taxes. Not us state, but states as in there’s 50 of them. Now, if you are from one of those states that doesn’t have an income tax, don’t tune out quite yet, especially as things move more virtual or as your clients move, as they retire and move closer to their kids or grandchildren, I find that most advisors, at some point, even if they are in a state that doesn’t have their own income tax, these issues will come up. So it’s great to have an idea of the range of issues that might be out there, and that you are prepared, as you have clients who might have multi-state or state transition issues come up. So, going to be great things in here, regardless of what state you find yourself in.

But to make sure that this is relevant and specific, I am going to give some examples that happened with some different states. So, one of the questions that came up working with this particular Bob and Sue, we had filed their tax return, and it was a learning opportunity for me, because we had gone through the return together. I thought we’d been really clear on where we paid taxes and why. And in this case, for Bob and Sue, it included a payment to the State of California, which is not where they were based, but they had a rental property there. And when the payment went through for those taxes, I got an email from Bob and Sue saying, “Hey, hold on a second. How come we paid any tax in California? We’ve never paid tax in California before. This doesn’t make any sense. We need to talk about this.”

And really, as I got on and had the conversation with them, we walked through it together, I’ll share some of the details in a second, but more than anything, what it made stand out to me, was that it’s really easy to have short-term memory loss when it comes to things that we think went in our favor, and it’s a lot easier for us to be skeptical or to be inquisitive, to really focus on things that we perceive as bad towards us.

And the reason I say that is that Bob and Sue had owned this property in California for years, and their impression was that they had never paid taxes there before. Going back through their tax returns, it was a little bit hit and miss. Their previous tax preparer hadn’t been real consistent with whether they reported taxes owed to the State of California.

Now, if you aren’t familiar with income tax in California, California is very much on the aggressive side of how they determine what is taxable in their state. And so anytime I’m dealing with issues with California, I’m going to start with the assumption that something is going to be taxable until I can prove otherwise, just because of how aggressive California can be. And rental properties is a great example. California has taken it to the point of requiring withholdings during the year and requiring, especially out-of-state residents to work with property management companies, so that these withholdings happened during the year. So, went through it all together, got it figured out that yes, in fact, they did owe these taxes, made sure it was really clear to Bob and Sue as to why, so we could set that expectation, make sure that this was clear to them going forward that this would come up.

It’s not surprising that there’s confusion around this, because not only does each state have different tax rates that they apply to income, but there’s also differing approaches to how a state even determines whether a taxpayer has taxable income in their state. For some states, it’s residency. For some states, it’s where the income was actually earned, or some combination thereof. The thresholds for when that becomes applicable is all different, and it’s all across the board. So, there’s really not a lot of consistency to it.

There are a lot of principles or rules in the different states that, at a high level, mirror federal tax laws, which, that can be helpful, but it seems like the exceptions are more prevalent than the norms, like with so many things in life. And so it’s not as simple as, “Well, I understand the federal rules, so the state rules must be the same,” or “My state has an income tax, and so as a client starts a business in another state, well, okay, the income tax rules there are going to be the same.” Or if the client moves to another state, whatever it might be, there’s really not much we can take for granted that the tax rules are going to be consistent or even logical.

So there was a few things that came up with California this year. That was the one at the top of the list for me, of just getting that really clear with Bob and Sue. Another issue that will come up at times when we’re looking at federal tax versus state tax, and this happens in quite a few states, is that tax, we’ll just assume for a client or a taxpayer that only has income in one state. Obviously, it’s more complicated as we have income in multiple states.
But we’ll look at the federal return, then we’ll look at the state return, and the taxable income will be different, federal compared to state. Even just the starting point. Because, states will have different whether they’re allowed to itemize or the levels of standard deduction, all those kinds of things, but even the starting point. So this came up with a couple of clients of, wait a second, I’m looking at my federal return and now I’m looking at my state return. One in particular that comes to mind was a couple in the state of Pennsylvania, said, “Okay, help, help me understand why my taxable income is different in each of these states.”

And so something that we see quite often is that there are states that don’t provide a tax benefit for contributing to things like 401ks and IRAs. And what the usually gets the focus is that in those states, distributions from 401ks and IRAs are not taxable. That’s where the focus gets placed, but the trade off to that is the reason the distributions aren’t taxable is because the contributions weren’t tax deductible. And so using Pennsylvania as an example for just about anybody who lives in the state of Pennsylvania, there’s likely to be a difference between federal taxable income and Pennsylvania taxable income, just right out of the gate, because at the federal level, we can pull things out of wages, such as 401k contributions, but for the state of Pennsylvania, that same deduction is not going to be there. So it’s something that as we review tax returns, whether as a tax preparer or as financial advisors, those are things to be on the lookout for, of not just that there is a difference, but does the difference make sense?
Because as I review tax returns, I’m looking both for potential planning opportunities, as well as potential issues, because using this same example from the state of Pennsylvania, one of the complicating factors there is then, okay, how do we deal with non-deductible IRA contributions and how that gets reported at the federal level, versus the state, and how does that get handled through the tax preparation software? And so that can confuse the issue a little bit. And so by taking the time to review both the federal and state returns and saying, okay, does the difference in taxable income between these two make sense, or is there something missing here, make sure that those non-deductible IRA contributions are getting reported correctly at both levels. It certainly adds just a little bit to the complexity, but we want to make sure that for our clients with income in states with an income tax, that when we talk about getting the entire tax return, that we don’t just mean the entire federal return, we mean the entire state return as well.

Another interesting one that came up this year was a client who was based in Missouri and also worked in the states of Oklahoma and Iowa. Now, this one was really interesting, because just like each state can have a different tax rate they apply, the states also differ on how they provide credits for the state tax you pay in other states. So Bob and Sue, in this case, were residents of Missouri, and really high level, the way Missouri approaches their state tax calculation is that they essentially take all of your taxable income and say how much would your tax be if you paid all of this based on Missouri income tax rates. And then if some of your income was earned in another state, and that state charged you income tax, you get a credit against what Missouri has calculated.

And so if you live in Missouri, but work in another state that doesn’t have an income tax at all, you would still pay state income taxes in the state of Missouri, because you haven’t paid anything to the other state. And then if the other state does have some kind of income tax, you’d get a partial credit for that. And what was really interesting for Bob and Sue in this case, is that compared to 2020, in 2021, they had earned a higher percentage of their income in a state with a lower tax rate. So just real, real rough numbers here, in 2020, they had earned a much higher percentage of their income in Oklahoma, which has a slightly higher income tax rate than Iowa. And the client was aware of this that, hey, I’m starting to earn more income in Iowa.

It’s a lower tax rate, so great. I’m going to pay less in state taxes. But what the trade off to that was that now the Missouri state tax was higher, because they have less of a credit. And so, again, sharing all this just to illustrate just the range of possibilities that are out there as you have clients shifting between different states, or potentially having income in different states, that these aren’t things to commit to memory, but they also certain things to disregard just because you don’t currently have someone in these states. We have so many people that will move around, whether intentionally or because of life events that come up, that these are great things to be aware of, to just know what to be looking out for and questions to be asking.

On the topic of clients moving between states, again, that this can happen at times, unexpectedly, life events, trying to be closer to family, whatever it might be, but also had a couple of clients this year come to me with a question of, hey, we’re getting ready to retire, and we’d really love to move during retirement, but we haven’t decided where we want to go. The question that followed that was, can you help us understand the best state to move to for tax purposes?

Get this question fairly regularly, and I don’t have a single state that I recommend to everyone. I just don’t. You can find great articles out there that will compare and contrast all the different tax liabilities, depending on what states you live in, keeping in mind that income tax is not the only tax. Every state is trying to generate revenue to fund whatever their priorities are. And so if they don’t have an income tax, what is their property taxes or their sales taxes? There’s all these different pieces. And so just right out of the gate, it’s really not just as simple as saying what state has the lowest income tax.

But really, more importantly than what the quantitative answer is, the reason I don’t give a single here’s where everyone should move for tax purposes, is that picking a state based on tax rates is a great example of why we shouldn’t let taxes be the driver of the bus when we’re making decisions. Right? It’s an important passenger. We want to understand the tax implications, but I want my clients to focus on what their goals are, and where they can best accomplish them, and then we’ll understand the tax implications. Or maybe if they’ve narrowed it down to a couple of places that would make sense, I can help with, okay, so what would be the quantitative impact of picking one state versus another, but I never want taxes to be the main driver of this decision.

We want to think about things like family, friends, and hobbies are the three that always come to mind for me of, again, what are your goals? Where are you going to best be able to accomplish those? And then let’s understand the tax impact. Every now and then, work with a client, I’m actually currently working through an analysis for a client. In this case, they’re in Washington state, considering living in Oregon, and just want to understand what that would mean from a tax perspective. So, great. When we get into those specific situations, absolutely, let’s run the numbers. Let’s make sure we have clear expectations going in. But even for them, as they came with that question, they understood that, okay, this is just one piece of information. This is not going to be the sole decision factor for what we do here.

As we talk about state taxes and the differences that can come up, one thing that we definitely need to keep in mind is the importance of timing of different life events, especially as it relates to retirement accounts. So mentioned it already, as we were talking about the state of Pennsylvania, there are a lot of states that don’t tax the distributions from 401k or IRAs. We want to look at the specific rules for the state that you’re in, because they all can vary a bit, but we also need to understand how the state looks at when the income was earned, when the contributions were made, and when then when the distributions are made.

And so moving between states isn’t just a matter of understanding how will that affect the income I continue to earn, but how will that impact as I pull money from my retirement accounts, if we were considering doing Roth conversions, is there a move that we’re considering that we should also factor in there? Quite often when the conversation around Roth conversions happens, it’s really focused at the federal level. And for clients who never intend to move, I completely understand that approach.

But as we talk about filling up a particular federal tax bracket, we also have to really understand the goals and intentions of the client, because if the client lives in a high income tax state, and already knows they’re planning to retire in a low or no income tax state, aggressively making Roth conversions based on the federal percentages might not put the client ahead, if they’re going to spend most of their retirement in a zero tax state. So it really all comes back to understanding our client’s goals, making sure we’re going beyond strictly what the numbers tell us.

One other somewhat interesting state tax related issue that came up a couple of times this tax season, as it does nearly every year, is taxpayers taking the time to review their tax return and saying, hold on a second. How could I have actually paid exactly $10,000 in state taxes? I’m looking at my schedule A here, and my deduction was exactly $10,000. How is that possible? Is there really a chance that that happened? Which, we talked about on previous episodes of making sure we’re getting clear with clients of what actually is deductible or potentially deductible.

And so even though this state tax cap has been in place for years now, commonly misunderstood area by taxpayers, especially as taxpayers move and maybe they haven’t had to deal with this before, and now it’s relevant to them. So it’s just another kind of point of education, or point of setting clear expectations for clients, as to how that interaction happens.

Okay. So even when we’re talking about state issues, we still want to talk about action items, we want to make sure that we can turn this information into something we can use to deliver value. So I mentioned it, but as we are getting tax returns, we have to make sure that we’re getting the state return as well. And this is one that does take reminding clients. I work with clients who are great about providing their tax return, but it’s an afterthought for them of, oh, you did need the state return as well. Okay. And so those are things I follow-up on and insist on, because there’s things to be learned, there’s value to be had from the state returns as well. So make sure you’re getting state tax returns in addition to the federal tax returns.

Action item number two is to make sure that as you’re making planning recommendations, that you are setting expectations for how taxes factor in. Your clients are inevitably, at times, going to see headlines or articles or things on social media that are specific to taxes, and they’re going to come to you and want to make decisions based on this most recent tax headline that they’ve found, so we want to set the expectation early and often that while taxes are important and we’re certainly going to consider them, but they are just a passenger on the bus. We’re not to make decisions solely for tax purposes. That way, when that article comes across their feed, you likely still to remind the client that that’s how you approach this, or how you’d like to approach it with them, but that you’re setting that foundation work, that you’re making sure that expectation is really clear.

Action item number three is to go out to retirementtaxservices.com, whether you are an RTS member or not, we have a tax reference guide that you can download and print and laminate that’s got a great map on the back of it with all the states, and just some general information about how different states approach income tax. It’s a great reference guide, especially to help as things come up with clients if considering moving or potential different state income implications, that you have that quick reference guide to at least know which direction you should be asking questions in.

Of course, last action item is to make sure that you are leaving us a five star review on Apple Podcasts or wherever you listen to your podcast. You’ve made this far through the episode, so clearly there’s something valuable here. We’d love for you to give us those reviews so we can keep sharing this message with more and more people. So, thanks for listening. And until next time, good luck out there. And remember to tip your server, not the IRS.