How Much Does State Tax Residency Still Matter?

While income tax paid by individuals primarily is based on the state in which they reside, certain forms of post-employment payments may be taxed differently and could lead to significant exposure.

First, some background on state income taxation: Generally, a person’s state of residency taxes their income regardless of where that income is generated. To prevent double taxation, the home state will allow a credit for tax paid to other states, but the net result is an individual ultimately paying tax on income from outside their home state at whichever tax rate is higher – their state of residency or the state where the income is sourced.

With state tax rates ranging from zero percent (Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming) to 13.3 percent (California), an individual’s state of residency can make a big difference. This is why a primary planning strategy is to change your state of residency prior to receiving significant income. Florida is often the target state in which to establish residency.

Taxes on post-employment payments

Corporate executives often receive payments upon leaving employment, or in the months and years thereafter. When there is time and ability to plan for state taxes regarding these payments, often the executive will move out of the high-tax state they worked in, to a low- or no-tax state prior to receiving the payments. Consider the example of an executive working in California and expecting to receive a $1 million post-employment payment. If they can change their residency to Florida prior to receiving the payment, they could save $133,000 in state income tax.

This strategy does not work for all types of post-employment payments, though. Specifically, it only works for retirement income, as defined by federal law. Nonqualified deferred compensation in the form of voluntary deferral plans, bonus plans, supplemental executive retirement plans, equity compensation, and others, usually do not meet the federal definition of retirement income. For those types of income, state taxation looks back to where the employee worked to earn the income, regardless of their state of residency when it is paid out. From the example above, if that $1 million payment does not meet the definition of retirement income, then California has a right to tax it regardless of the individual having moved to Florida.

The federal definition of retirement income for this purpose of state taxation includes expected types of retirement income like distributions from a 401(k), IRA, SEP, 403(b), or 457 plan. Distributions from these plans can only be taxed by the state of residency when received. In addition, some distributions from nonqualified deferred compensation plans can meet the definition of retirement income. If the distributions are annuitized over either the recipient’s life expectancy or at least 10 years, then these payments will be treated as retirement income and can only be taxed by the state of residency at the time of receipt.

Also meeting the definition of retirement income: post-employment payments (lump-sum or annuitized) from a plan maintained solely for the purpose of providing retirement benefits in excess of the limitations on 401(k) and similar plans.

As you can see, when someone receives post-employment payments, the devil is in the details about whether they will be taxed in the state of residency or the state where the income was earned. Often the company plan will be such that the individual has no choice but to be taxed where the income was earned.

In our second article in this series, we’ll examine residency and the sale of a flow-through entity. You can read this piece here. 

Additional Resources

If you would like to discuss the information above, or any areas where Rehmann can assist, please reach out to your Rehmann advisor. You may also contact us at info@rehmann.com.

 

Published in Tax

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