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Make your plan for nontaxable retirement income

Jan 15, 2024

State taxation of retirement income can impact you whether you’re currently in retirement or preparing for retirement down the line. But with proper planning, your retirement income could be nontaxable to any state, anywhere.

The key is to understand critical factors, including federal restrictions and what qualifies as retirement income.

Federal restrictions on state taxation of retirement income

States are generally entitled to tax the source income of their nonresidents.

 Prior to 1996, many states, but mainly California, sought to tax the pension income of retirees who earned the income while living in the state, but who put the money in a tax-deferred retirement plan until they had moved away. In response to complaints from these retirees, most of whom had moved to non-tax states like Florida or Nevada, then-President Clinton signed P.L. 104-95, the Pension Income Tax Limits Act (PITLA), codified at 4 USC Section 114, into law in 1996.

However, the PITLA prohibits states from taxing the retirement income of nonresidents, meaning that the only state that can legally tax an individual’s retirement income is the state where the individual resides at the time the income is recognized.

This federal law can be a powerful tool for individuals to legally pay no state income tax on their retirement income. However, knowing what retirement income is — and what it isn’t — is vital to ensuring you know exactly what the law protects.

PITLA defines the term “retirement income” to include income from sources such as the following:

Source of income

Governing Internal Revenue Code Section

Description

Qualified trust

IRC 401(a)

Stock bonus, pension, profit-sharing plan

Simplified employee pension

IRC 408(k)

Individual retirement account or annuity in effect immediately before retirement begins

Annuity plan

IRC 403(a)

Amount actually distributed to any distributee shall be taxable in the year in which so distributed

Annuity contract

IRC 403(b)

Employees of 501(c)(3) charitable organizations, educators, ministers

Individual retirement plan

IRC 7701(a)(37), 408(a) and 408(b)

Exclusive benefit of an individual or his beneficiaries funded with cash where the trustee is a bank and no part of the trust funds are invested in life insurance contracts

Eligible deferred compensation plan

IRC 457

Compensation deferred under an eligible plan maintained by an eligible employer, state or political subdivision of a state and any other tax-exempt organization

Government plan

IRC 414(d)

Established and maintained by the government, includes Railroad Retirement Act of 1935 or 1937 and an Indian tribal government

Nonqualified deferred compensation plan

IRC 3121(v)(2)(c)

Series of substantially equal periodic payments (not less frequently than annually) made for the life or life expectancy of the recipient or a period of not less than 10 years

 

While there may be opportunities to structure compensation to fall within the above categories, approach these efforts with caution. 

For example, except for very small organizations, it can be impractical to structure a nonqualified deferred compensation plan to provide substantially equal periodic payments for the time periods described above.

Another key issue to consider is distinguishing retirement income from related but distinct forms of compensation. For example, according to Minnesota Revenue Notice #08-10, retirement income does not include severance pay, equity-based awards or other nonstatutory deferred compensation.

There are also cases when deferred compensation only sometimes qualifies as retirement income because the Internal Revenue Code defines that term negatively (what it is not) instead of positively (what it is). To illustrate, deferred compensation is not restricted stock compensation subject to Internal Revenue Code Section 83(b), vacation benefits, sick leave, compensatory time, disability pay, severance pay and death benefits. 

Other state preferential treatment of retirement income

Even though federal law limits states’ ability to tax certain kinds of retirement income, some states voluntarily exempt certain types of retirement income.

Some retirement income-friendly tax policies that states have adopted for their residents include:

State

Does not tax retirement income, including Social Security Income

Does not impose a personal income tax

Exclusion amount/Exemption specifics

Alaska

 

X

 

Colorado

X

 

$20,000 at least 55 or $24,000 65+

Delaware

X

 

$2,000 of regular pension or $12,500 of military pension, on or after 1/1/22. Those age 60+ exclude $12,500 of regular pension.

Florida

 

X

 

Hawaii

X

 

 

Idaho

 

 

Fully exempts railroad retirement benefits and social security.

Illinois

X

 

 

Iowa

X

 

$6,000 MFS, $12,000 MFJ as long as taxpayer is 55+ or disabled

Kentucky

X

 

$31,110

Louisiana

X

 

$6,000 as long as taxpayer is 65+

Massachusetts

X

 

Except from private and public pensions

Michigan

X

 

Based on year taxpayer was born

Mississippi

 

 

Certain U.S. and state pensions, annuities and retirement allowances

Nevada

 

X

 

New Hampshire

 

X

 

New York

 

 

Certain U.S., state and local pensions. $25,000 for certain annuity income if at least 59.5

Oklahoma

X

 

$10,000 from IRAs if over 65

Pennsylvania

X

 

After reaching 59.5

Rhode Island

X

 

Certain pension, deferred comp, military plans, annuities and similar sources

South Carolina

X

 

$3,000 under 65, $10,000 after 65

South Dakota

 

X

 

Tennessee

 

X

 

Texas

 

X

 

Utah

 

 

Fully exempts railroad retirement benefits

Washington

 

X

 

Wyoming

 

X

 

Other considerations

Even if you’ve researched about whether your income is retirement income and feel confident, your employer may muddy the waters by reporting it on the wrong tax form.

New York’s 2008 Musliner case, a taxpayer victory, illustrates the headaches that can accompany the reporting of retirement income on a Form W-2. In this case, the taxpayer was originally receiving a 1099-R; however, when the plan administrator changed, they also received a W-2 that marked nonqualified plans in box 11. When the taxpayer later claimed a pension and annuity income subtraction, the New York Department of Taxation and Finance denied the deduction on the ground that the income had been reported on Form W-2.

Because New York’s income tax law excluded income from pensions and annuities, the key question that New York considered was whether these payments were pension/annuity payments (exempt) or wages (not exempt).

The New York Division of Tax Appeals, however, held that the issue of whether the income was reported on Form 1099-R or Form W-2 had nothing to do with the income’s eligibility for New York’s subtraction, stating that “the nature of the payment itself, and not the manner in which the payor reports that payment for FICA … purposes, determines the correct tax treatment thereof” under New York tax law.

To avoid similar issues, it’s important to talk to your financial planner and your employer’s HR department about whether your post-employment income should be reported on Form 1099-R (retirement income) or Form W-2 (wages). 

How Wipfli can help

Get tax services that fit your future with Wipfli. We can help you navigate the complex and often loosely defined rules for deferred compensation so that you can maximize your retirement. Contact us today to learn how we can help you be confident in your tax planning.

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Author(s)

Mandy R. Riles, CPA
Tax Manager
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