lev·er·age (verb): Use (something) to maximum advantage.

Picking the right state for retirement can save you a great deal in taxes. Leveraging state tax laws can be an important part of your retirement plan. But it’s trickier than you might think.

When you’re working, it’s relatively simple.

  • Does this state tax income?
  • If so, how much–what are their state income tax brackets?
  • How high are the other local taxes (sales, property)?

But in retirement, not all income is equal. 

  • Not all Social Security is taxed at the federal level.
  • In some states, they do not apply state income tax to Social Security at all! But they do tax other sources of income (Arkansas is in this boat).
  • Some states do not tax government pensions.
  • Some states do not tax income from IRA, 401k, or pensions.
  • Some states give an exemption on a portion of income derived from retirement vehicles. 


Arkansas is in a unique position. The Natural State is a perfect example of state income tax getting more nuanced for retirees.

  • Arkansas taxes income in the generic sense. If you work in Arkansas and make a considerable income, you pay a state income tax. Arkansas also taxes capital gains (with a 30% exemption).
  • Arkansas taxes distributions from pre-tax retirement plans.
  • Arkansas DOES NOT tax Social Security income.
  • Arkansas does not have an inheritance tax. 

New Mexico & Colorado

I include these together because these mountain states have very similar retirement tax rules.

  • Both have a state income tax just under 5%.
  • Both states enjoy some of the lowest property taxes in the country.
  • Both states do not have an inheritance tax.
  • Both states offer an exemption on a portion of retirement income.
    • Over 65, $24,000 of income from retirement sources is exempt from state income tax in Colorado.
    • Over 65, $8,000 of income from retirement sources is exempt from state income tax in New Mexico.
      • Note: New Mexico phases out this exemption for income over $51,000 MFJ. So, if you have considerable assets, you will likely be phased out.

Tax-Free Income States

This is rather obvious, but it sets up my next point well: These nine states do not tax income at the state level. The states are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming.

But Illinois, Mississippi, and Pennsylvania join this club when it comes to retirement distributions. Any income from a 401k, IRA, or pension is not taxed at the state level in these three states.

Alabama and Hawaii do not tax income from pensions–but do tax income from 401k/IRA sources.


Getting Strategic

I am a huge Kansas State fan. I, along with nearly 50 relatives, got my degree from KState. Most people associate Kansas State with our legendary football coach, Bill Snyder.

What made Snyder so special was that he could always find small opportunities to leverage into unexpected wins.

During his first tenure (’89-’05), he was one of the first coaches to recruit junior college players. He exploited this strategy like a master. From 1994-2003, Kansas State was ranked in the top 10 at some point in the season every year and averaged 10 wins each year. 

This level of success is virtually unattainable for any college football program outside of the 7-8 bluebloods. In 1998, we were seconds away from the national championship game before a miracle Texas A&M upset.*

During Snyder’s second tenure (’09-’18), college football had changed significantly and he wasn’t able to recruit the same level of athletes he did during his first run. But he used special teams, pace of play, and a unique offense to leverage incredible success. In just his 4th year, he again had Kansas State 10-0, ranked #1, and on the brink of a national championship appearance.


What Does College Football Have to do With Retirement Taxes?

Snyder was called a wizard because he found small opportunities and exploited them in massive ways.

You need to do the same with retirement taxes. The way to leverage your tax opportunities is through asset location.

If a state doesn’t tax some of your assets, but they will tax other assets–what should you do?

You should make sure that the tax-free assets grow more than the assets subject to income tax. If you’ve read the story of Jacob and Laban in the book of Genesis (Jacob devises a plan for his livestock to grow more than Laban’s), this is a similar idea.

The term for this strategy is asset location.


How to Use Asset Location 

Asset allocation is how you broadly invest your money–how much you put in U.S. stock relative to International stock relative to bonds. Asset location is how you implement that allocation across your different accounts.

Many investment firms will follow a protocol similar to this:

  • Input your data (age, assets, income needs, etc.)
  • Give you a risk tolerance survey
  • Based on both items above, your portfolio will be one of eight canned model portfolios they put every client in.

Essentially, most firms use asset allocation and asset location interchangeably. If you have a Roth, brokerage, and IRA account, they will take your funds and throw the exact same portfolio in all three accounts, like the image below.

Missing Roth Opportunities in Retirement

This is a pretty substantial mistake. If some of your accounts have a massive tax benefit like a Roth (doesn’t get much better than tax-free), then you should place the positions with the absolute highest growth potential there.

If other accounts are punished for growth in the form of higher taxes, you should put your lowest growth positions there.

Using Roth in Retirement

It’s pretty intuitive. If your IRA is a ticking tax bomb, implementing a different portfolio in each account, as the image above shows, can be a great solution. As the image shows, you likely won’t follow this idea completely because most IRAs are far larger than Roth IRAs (i.e. you are going to have some stock or real estate exposure in a pre-tax IRA).


 What About Timeframes?

I mention this one idea a lot: Timeframe should dictate how you invest.

If you need money in the next two years, you probably shouldn’t put it in the stock market.

But if you’re not using a specific account for ten+ years, you should likely put the vast majority of it in a diversified stock portfolio.

Timeframes should be an even larger dictator in your investments than your risk tolerance. And a way larger dictator than where you think the market is headed in the short-term. With that being said, asset location works very well with this rule.

A Roth account should be the absolute last money you touch. If you can compound your money in a tax-free account, you should let that compounding work for decades before touching it. You should empty virtually every other account in your balance sheet before touching the Roth.

In other words, I’m not worried about a market crash ruining an asset location strategy. I’m worried about missing compound interest in a Roth IRA. I don’t really care what’s happening in your Roth over an 18 month period. I deeply care what happens in your Roth over a 2-3 decade period.

Important note: This is why Roth conversions can be so powerful. If you hit age 70 and haven’t done any Roth conversions, you probably won’t have any Roth assets to implement this strategy with.


What About Social Security?

Social Security strategy can also be treated like a Roth depending on your state’s tax laws. What do I mean?

If your state does not tax Social Security income, but does tax other income, it would behoove you to delay Social Security to maximize your benefit.

Just like the Roth, you want to maximize the value of tax-free assets. I really like delaying Social Security in many situations anyway, but if your state does not tax Social Security, that’s another reason to delay and maximize your benefit.


*This game is why, despite my wife choosing Texas A&M for law school, I will always have a grudge against them.