Clients Are Not Locked Into High-Tax States
CFP® Certificants in the News
encourages membership in the Financial Planning Association. Later in this article, we will reference a highly topical article appearing in the Journal of Financial Planning.
We will feature a strategy that high-income clients can use to slash their state income tax rates in this report. But first, let’s admit that federal income tax planning can take most of the tax planning oxygen out of the room. Yet, even in states with moderate income tax rates, the top marginal rate can soar to over 50% in combined state and federal income taxes. We’ll pull back the curtain on key takeaways dealing with the current state of state income taxes, lament the lack of an “innocent until proven guilty” presumption, contrast residence with domicile, and close with caveats and opportunities.
The Current State of State Income Tax Rates
Forty-two states levy an income tax; most of these states levy an income tax of 6% or less but, regrettably, other states are income tax collection “overachievers.” For example:
- The “award” for highest state income tax rate goes to New York, with rates as high as 15%,
- California is a close runner-up with rates that can exceed 13%, and
- Even the paradise state—Hawaii—has a top marginal rate of 11%.
But that’s not all; the government adds insult to injury. Federal itemized deductions for state and local taxes paid are limited to $10,000 under current law.
How can CFP® certificants help clients address high state income tax rates? One effective strategy, changing one’s state of permanent residence (domicile), is often dismissed from consideration because of the perceived complexities and other factors. However, establishing domicile in a state with low-to-no state income rates should be considered for clients with the flexibility to move to another state, according to an article by Eric J. Cofill published in the October 2021 edition of the Journal of Financial Planning. As long as the move is not an income tax sham, the strategy can save tens of thousands or more in state income taxes for clients with higher than average income. The taxpayer merely has to take a few straightforward steps to prove domicile in the new state to achieve these potential savings.
Guilty Until Proven Innocent
This next statement may not surprise you. Apparently, the constitutional presumption of innocence in criminal matters does not extend to assessments by government tax collectors. According to Mr. Cofill “As a general principle, proposed tax assessments issued by state tax agencies are presumed to be correct, and the taxpayer carries the burden of proving that assessments are erroneous [emphasis added]. In the context of a residency audit, the burden is upon the taxpayer to prove… that they have changed their…domicile.”
Residence vs. Domicile
According to the legal profession, one’s domicile is simply one’s state of permanent residence. For example, if you’re taking that long-planned two-week anniversary trip to Bora Bora, your feet may reside on island sand for two weeks, but your state of domicile does not change.
Quoting Mr. Cofill, “Most change-of-residency exercises involve two interconnected principles under a state’s unique law: (1) domicile; and (2) residency. Typically, a person can only have one domicile but can have multiple residences. [A common] approach to addressing these interrelated principles [is] the importance of not only developing ties with the new state but also of breaking ties with the former state.”
Although each state may have its own legal nuances, persuasive factors that generally determine a taxpayer’s domicile include where they spend the most time, vote, and demonstrate other connections to their new state. Other connections include the location of:
- Family,
- Owned property,
- The schools their children attend,
- Registration state on driver’s licenses, business licenses, and passports,
- Their primary banking relationship, and
- Physicians.
Caveats and Opportunities
Caveats
Before your client starts counting the tax savings from a potential change in their state of domicile, they should consult with legal and tax counsel in both the existing and future state of domicile. For example:
- Merely owning a vacation home in at least one particularly aggressive state may open the taxpayer to that state’s taxation of all income, not just income from the taxpayer’s state of domicile, and
- Some states with low or no state income taxes will have other taxes such as capital gain taxes, sales taxes, death taxes, and portfolio (intangible property) taxes.
Opportunities
- The states of Nevada, Georgia, Florida, and other states either have no state income tax or exclude all or a significant part of Social Security, annuity, IRA, and qualified plan (think 401(k)) income from taxation, and
- Property and estate tax taxes are either zero or relatively low in states such as Wyoming and Georgia.
Bottom Line
Your high-income clients can save tens of thousands, if not more, by changing their state of domicile. However, experienced attorneys and tax professionals should be engaged to avoid expensive pitfalls.
Disclaimer
The information presented herein is provided purely for educational purposes and to raise awareness of these issues; it is not meant to provide and should not be used to provide legal, compliance, investment, tax, estate, insurance, retirement, or financial planning advice of any kind. An experienced and credentialed professional should be consulted in advance with respect to the issues discussed herein. There are variations, alternatives, and exceptions to this material that could not be covered within the scope of this article.
