Forbes | Personal Finance |
With deference to Led Zeppelin, many high-income earning Californians are singing a slightly different tune…
Made up my mind to make a new start
Going To . . . Leaving California with an aching in my heart
What is the source of the aching? Taxes. At 13.3%, California has the highest income tax rate in the country. To provide even more heartache, with the passage of the Tax Cuts and Jobs Act in 2017, state and local tax deductions are limited to $10,000 on the federal tax return. For many California residents, or for that matter, residents of any state with a higher income tax, the dream of moving to a lower tax state (or even states with no income tax!) is real.
Those with businesses or jobs find it difficult to leave a high tax state, but moving to a lower tax state can be much easier for retirees who are not tethered to a location. Giving up a stable source of income can be scary. Those looking to retire soon may dream of having their retirement income go a little further by paying less tax. On the other hand, maybe you seek adventure in retirement and are considering renting your house and traveling the United States or even the world. There are many reasons why you may want to move to a lower tax state, but this is an area ripe for problems if not done correctly. I recently recorded a podcast “Moving Out of a High Income Tax State” that explores this in more detail.
The first question you need to ask yourself is if it is worth it. Does it make sense to pack up and move to a new state to cut your tax bill? The answer is a definitive “it depends.” If you are not paying a lot of state tax now and do not expect to pay a lot of tax in the future, it probably doesn’t make sense. For example, if last year you paid $4,000 in state income tax, is it really worth selling your house, hiring a mover, and setting roots somewhere new? For most people it wouldn’t be worth it. However, if last year you paid $30,000 in state income tax and you expect to pay that amount for years to come, it might make sense.
When I run financial plans and retirement plans for clients who are intrigued about what their finances will look like if they moved, I routinely see big jumps in the projected success of their plan when we model them moving to a state with lower (or no) income tax. For example, for one client recently the success of their retirement plan was 83% if they stayed in California but increased to a 94% success rate if they moved to Nevada. That’s a significant boost in the potential success of their retirement plan. Of course, it would require significant changes on their part and not everyone is interested in starting over just to reduce their taxes. However, if you are intrigued and would greatly benefit from reducing your taxes, get informed and be diligent about following the rules.
Speaking of rules, there is a great deal of bad tax advice when it comes to minimizing or avoiding state income tax. How many times have you heard, “You only have to live 183 days in another state to be a resident”? If only it were that simple.
Before you rent a U-Haul and head for another state, there are a few things to think about. For this article, let’s imagine we have a couple who live in California and have been diligently paying state income tax for decades. They are approaching retirement and want to buy a second house in neighboring Nevada (which not-so-coincidentally has no state income tax). Even though they are retiring, they anticipate earning several hundred thousand dollars a year in interest, dividends, and part-time consulting work. A friend tells them they can avoid all of California’s big bad income taxes (which may amount to over $40,000 a year for them) as long as they are not in California for more than 182 days in the year. Seems simple enough. A couple of months in Nevada, then a European trip, then back to California for a couple of weeks, and then Nevada, etc. They even go so far as to buy a large calendar to plan their year so they can make sure they are out of California for at least 183 days. All goes smoothly until California decides to audit them, and they find they have to pay California tax on all of their income along with interest and penalties. Ouch.
Where did they go wrong? Could they have done something to prevent this? The answer is a definitive maybe. Here is what you need to know…
Each state is different, but California defines a resident as any individual who meets either of the following:
• Present in California for other than a temporary or transitory purpose.
• Domiciled in California, but outside California for a temporary or transitory purpose.
According to the State of California Franchise Tax Board publication, Guidelines for Determining Resident Status, “Although you may have connections with another state, if your stay in California is for other than a temporary or transitory purpose, you are a California resident.” And, to be clear, if you are deemed a California resident, your income from all sources is taxable by California. What does this mean for our couple in the example above? Any income they make as consultants – even if in Nevada – would be subject to California state income tax.
There are two key concepts you must be familiar with if you have dreams of leaving a higher income tax state for the greener and less taxed pastures of another state: domicile and residency.
According to California, domicile is defined for tax purposes as the place where you voluntarily establish yourself and family, not merely for a special or limited purpose, but with a present intention of making it your true, fixed, permanent home and principal establishment. It is the place where, whenever you are absent, you intend to return. Although the couple may have resided in Nevada, their true and permanent place of establishment remained in California. Do you notice there is no mention of the number of days in California versus out of California? That’s because California doesn’t go by the 183+ day rule. It’s possible to never touch foot in California in a given calendar year but still be subject to California income tax! This is because domicile is less about days (although still a factor) and more about intent. To make matters more difficult for our fictitious couple and you, the burden is on the taxpayer. You must prove your intent if you are audited.
How can you prove your intent? The maintenance of a residence (e.g., house, condo, apartment) in California is a significant factor in establishing domicile in California according to the Franchise Tax Board. Therefore, not having a residence in the state is important. How can you make it clear you are not domiciled in California? The Franchise Tax Board suggests all of the following:
• Abandonment of your prior domicile.
• Physically moving to and residing in the new locality.
• Intent to remain in the new locality permanently or indefinitely as demonstrated by your actions.
In other words, sell your residence in California, pack up and move to another state, and take actions that make it seem like you are actually long-term residents of the other state. Here are a few of the actions California highlights:
• Amount of time you spend in California versus amount of time you spend outside California. Although California doesn’t have the simple 183+ day formula for determining residency, if you are in the state for more than nine months in a calendar year, you are automatically considered a California resident.
• Location of your spouse and children.
• Location of your principal residence.
• State that issued your driver’s license.
• State where your vehicles are registered.
• State where you maintain your professional licenses.
• State where you are registered to vote.
• Location of the banks where you maintain accounts.
• The origination point of your financial transactions.
• Location of your medical professionals and other healthcare providers (doctors, dentists etc.), accountants, and attorneys.
• Location of your social ties, such as your place of worship, professional associations, or social and country clubs of which you are a member.
• Location of your real property and investments.
• Permanence of your work assignments in California.
Keep in mind that the state tax authority will look at your entire situation. There is not one single action that will prove intent – they examine the totality of your actions. As a result, I would suggest doing as many of these items as possible that California has highlighted:
• Cancel your California driver’s license and obtain a new one in your new state.
• Cancel your California library card and get a new one in your new state.
• Sign up for local newspaper delivery in your new state.
• Vote in your new state.
• Eliminate as many ties to California as possible (close local bank accounts, gym memberships, clubs, associations).
• Join organizations or clubs in your new state.
• Hold holiday family gatherings in your new state.
• Use the actual date you moved to the new state instead of defaulting to January 1st of the year you moved. According to CPA Jeff Levine, too many tax preparers habitually use January 1 because it is clean and easy to start the new year in the state, but Jeff argues that very few people truly move on January 1.
Does it make sense for you to move to pay less in state income taxes? Work through your numbers and talk to your tax preparer and financial advisor about how it would impact you. It’s a big decision so make sure you have all of the facts and that you have a good team guiding you.
Lastly, if you are audited by the California Franchise Tax Board and asked if you plan on going back to Cali, channel your inner LL Cool J and answer, “I don’t think so.”