Where in the World …
In Part 9 of the Pension Series a reader’s question prompted me to research the interplay between the U.S. Federal tax code and pensions. My reader, Mr. Yankee, wanted to know what options existed to minimize Federal taxes when pension payments started for him and his wife, Mrs. Doodle. I found a few specific instances to defray some Federal tax, but nothing major. Turns out Mr. Yankee already knew the most powerful tax options available to him. What did Mr. Yankee know? He knew that in the U.S., geography mattered when it came to taxes — specifically at the State level.
For my one non-related international reader, it may seem strange, but in the U.S. we tax income more than once. We typically tax it at the Federal and the State level, and sometimes even at the local level. Furthermore, pension payments typically count as income no matter the source. As I chronicled in Part 9 of the Pension Series, everyone who receives a pension is (typically) subjected to Federal tax. However, not every State in the Union taxes income. Nor does every State tax pension payments as income.
Other taxes such as sales, property, and gasoline are also taxed differently depending on the State, County, and City. Thus, if you’re an American who receives a pension, the State, County, and City you retire in, or to, matters … a lot. I’m not talking chump change either, but thousands of dollars a year. This, of course, opens up to all sorts of Geographic Arbitrage, or Geoarbitrage, opportunities to future pensioners when planning for retirement.
Yet, everyone’s situation is different. One place does not fit all. I don’t need to point out the thousands of different variables like kids, college, access to healthcare, family, or climate that influence people’s decision on where they retire. People value different things at different times in their lives. It’s the tried and true mantra that personal finance is just that … personal. There are trade-offs to consider too. For example, a State that doesn’t tax income must still raise revenue for roads, schools, and other government functions. It usually comes in the form of higher property and/or sales tax.
That said, as a potential future pensioner, some issues are more important than others when considering where to retire. The top of that list is probably whether your pension will be taxed at all. I’m not saying it tops all other considerations, but if such a place exists it certainly deserves serious consideration when putting together your retirement plan. So is there any place like that?
Possibly, and not just for U.S. citizens either.
The Golden Albatross in Portugal
How’s your Portuguese? That was a rhetorical question. Your answer doesn’t really matter. My family and I spent a week in southern Portugal, don’t speak a lick of Portuguese, never had an issue, and loved every minute of it. Portugal has a lot to offer: sun, beaches, surf, history, culture, great food, friendly people, and an interesting tax code. Turns out if you Google “Portugal” and “Taxes” you quickly find references to their Non-Habitual Residence (NHR) tax regime. What’s NHR you ask? Apparently, it’s a program to entice worker’s in high valued industries to move to Portugal by offering them tax incentives.
However, NHR also provides expat retirees who qualify up to 10 years of tax-free foreign income in Portugal. That foreign income includes pensions, but provisions differ depending on the expat’s country of origin. If you’re from the UK, you might be the biggest winner here. There’s a lot of information online about NHR’s benefits for expat retirees who earn pensions. I’m no expert in UK taxes, but from what I’ve read, it appears UK citizens could live for up to 10 years in Portugal under NHR and receive their pension tax-free! My research did not reveal the impact for other EU members, then again I wasn’t really looking. However, if you’re Finnish, I’m sorry. I found a reference that the Finnish government renegotiated its tax treaty with Portugal to end this practice by their citizens.
Any UK citizen, of course, should keep in mind that Brexit holds the potential to close this tax loophole … I mean close this tax provision in the UK/Portugal tax treaty … for them as well. As of the publication date for this article though, it’s still open season. Which means for my two non-related British readers, break out your single pair of shorts, get moving, and order a Sagres beer for me when you get there! I’ll be along shortly to celebrate with you on your awesome luck, unless of course if you’re from Liverpool.
The Elusive U.S. Golden Albatross in Portugal
For expat U.S. pensioners, it’s less clear as to whether NHR provisions provide a lot of tax benefits. I’ve seen conflicting and confusing reports. As I’m prone to do in cases like this, I went to the IRS website. I ended up reading Publication 54, “Tax Guide for U.S. Citizens and Resident Aliens Abroad”. It proved a thrilling read. Let me save you the pain, and simply say that how U.S.-based pensions are taxed for U.S. expats retired overseas very much depends on the U.S.’s tax treaty with the chosen country for retirement. Thus, I found and read the U.S.-Portugal tax treaty. Unfortunately, it left me even more confused.
Rarely do I find a document’s language so impenetrable that I cannot at least understand the gist. This treaty bested me though. I even tried to drink a few beers to see if it made more sense, it didn’t, but at least the beer tasted good. That said, the one thing I took away from the treaty is that public and privately earned pensions (as defined in the U.S.) are taxed differently according to the treaty. One type is taxed by Portugal, and one is taxed by the U.S.
Frustratingly, I couldn’t figure out which is which, so I took to Google again. Unfortunately, the results proved inconclusive. I found some expat tax forum threads referencing the NHR process and pensions, but they were neither expansive nor particularly well written. I found an oblique reference in a guest post on Big Ern McCracken’s blog, Early Retirement Now, stating that pensions are not taxed in Portugal. However, my research leads me to believe that assessment is at best a generalization of what I just described — not a specific U.S.-based pension analysis.
What should a U.S. pensioner do then if Portugal interests them?
Caveated by the fact that I’m not a tax expert, here is what I think. The U.S.-Portugal Tax Treaty makes specific provision for taxing public and private U.S. -based pensions differently. Although I cannot determine which type of pension is taxed in Portugal, whichever type is taxed, MAY be subject to the 10-year tax exemption in the NHR regime. If you are a future pension earner from the U.S. and interested in retiring to Portugal because of this possibility, you should do some research. The answer may be out there. In addition, once you do the research, I would engage a tax professional with experience in international tax law to help you make a determination if the NHR is something that benefits you in a major way. If you have any luck, let me know so I can update this post and my retirement plans!
Back in the U.S.S.A.
OK, that’s probably the most internationally applicable topic I’ve written about to date. My typical comfort zone is U.S.-based pension and retirement topics. While I may branch out in the future on other international pension-related topics, for now, I return to my comfort zone. Let’s discuss Geoarbitrage opportunities in the U.S. when it comes to pensions.
The first thing you should know is that 13 States don’t tax pensions (or social security for that matter). Some of those should seem immediately familiar because they are the seven States without income tax:
- South Dakota
Two more states, New Hampshire and Tennessee, only tax dividends and interest. Then there are the States like Alabama, Mississippi, Pennsylvania, and Illinois that don’t tax pensions or Social Security. There are other States that mix and match some of their taxes on pensions and Social Security. You can find a comprehensive, although slightly different, list at Retirement Living.com. It’s a good starting point, but don’t consider it definitive. Finally, as I learned from Mr. Yankee last week, some State’s like New York don’t tax pensioners from their own State’s pension system. So if you’re in a State pension plan, you will want to check and see what the provisions are for your State’s plan.
As I stated in the introduction, every place has its trade-offs. On the face of it, the States without income or pension taxes might seem extremely attractive as a future retirement location. However, as Chris Kahn at BankRate.com points out, States without income tax typically have higher sales and property tax to compensate for a lack of revenue generated through income tax. Thus, a map like the one at The Tax Foundation, which tracks State sales tax may prove more useful than simply tracking which States do or do not have State income tax. If you plan to own a home, then a property tax tracker from Retirement Living.com might be of use as well.
Not to get too bleeding heart on anyone, but there is another aspect possibly worth considering to living in a State without an income tax. Replacing State income tax with a higher sales tax tends to hit lower income people harder than the rich. Why? Well, it takes away a progressive income-based system designed to tax the rich at higher rates than the poor, and replaces it with a flat rate.
Flat rate taxes may seem like a fair way to tax everyone equally, but in fact are unfair on the poor. They force the poor to spend a larger percentage of their total income on taxes than the rich. This strains already overburdened public services (such as Medicaid) heavily funded at the State level. That may or may not seem important to you as you head into retirement. However, living in a State whose poor are overly taxed and forced to rely more on strained social services may not be the ideal retirement atmosphere you envisioned.
In the end, it may also prove useful to cross-reference State tax regimes with a State-by-State cost-of-living list, rather than just looking at the tax situation. As I can attest from living in Hawaii, a moderate sales tax and one of the lowest property taxes in the U.S. doesn’t mean much when almost everything you buy must be imported via ship from the mainland or overseas. Shipping drives up costs, which in turn drives up the cost-of-living. Thus, a quarterly cost-of-living tracker like the one from the Missouri Economic Research and Information Center (MERIC) which tracks the cost-of-living in all 50 States (plus Washington D.C.) may prove more useful than just a tax tracker. When I cross-reference the list of 13 States that don’t tax pensions to the MERIC cost-of-living list, Tennessee and Alabama are the first two States to appear on both.
Numerous interactive websites allow you to drill down to city-by-city comparisons of the cost of living. Many in fact allow you to compare cities from all over the world to one another. No one probably remembers, but in my Test Your Retirement Plan post, I referenced a website I used to compare European cost of living (where I was living and tracking my finances at the time) to Southern California cost of living in order to adjust my retirement budget numbers accordingly. Of course, looking at cost of living, rather than the tax implications of Geoarbitrage to pensioners, strays into a heavily covered area. Numerous Financial Independence (FI) bloggers write specifically about geographic arbitrage if you’re interested. Go Curry Cracker is the most oft-cited Geoarbitrage website I see and hear referenced on the blogs I read and podcasts I listen to. Good Luck.
Unless you’re a UK pensioner with an interest in moving to Portugal, I have no clear Geoarbitrage recommendation for you. Geoarbitrage provides some pensioners the ability to stretch their pension money further. This could make a huge difference in the quality of their retired life. These savings typically appear as some sort of tax relief or cost of living decrease. That could mean a move around the world, to a neighboring State, or simply a different City.
Every location has trade-offs though. While that isn’t an argument for staying put in your current State or Country of residence; it is an argument for careful consideration prior to moving. Since everyone values different things at different periods in their lives; it may prove worthwhile to determine what you value prior to retirement. Finally, if minimizing taxes is something you value, I highly recommend consulting a tax professional. Just make sure they have expertise in the area you’re looking to move.