State Taxation of Retirement Distributions

How will your state tax your retirement distributions? That’s a cost which you will need to take into account as you set your savings goal.

Most states have their own income tax. A few states, like Florida, have no income tax. (What fuels their government? Sunshine? ) Of the states that do impose an income tax, many have chosen the expedient scheme of piggy-backing onto the federal income tax system by starting the state tax calculation with the income and deduction figures from your federal tax return, and then adding and subtracting a few adjustments from there. So in these states, if a dollar of distribution from a retirement account is taxable for federal purposes, it will be equally taxable for state purposes, at least initially. And in these states, if—as with a well-timed Roth IRA distribution—it’s not taxable for federal income tax purposes, then it won’t be taxable for state income tax purposes either.

Some states have enacted a special benefit for their senior citizens. New York, for example, exempts up to $20,000 of otherwise taxable retirement income from state tax. Thank you, New York!

Imagine this scenario, which is not atypical. You work all your life in a high tax state, like New York or California. During all those years you are earning contributions to retirement accounts which are not being taxed. Some contributions are made by your employer, and some are made by you (think 401(k)). These contributions have gone into the Tax Time Machine, as described in January 29’s post. Then you retire to sunny Florida—which has no income tax—and you start taking distributions from these accounts. “Wait a minute,” says the state of California, “you earned those dollars when you were working here. We want to collect some of that tax revenue, no matter where you live. We’re coming to get you!”

Can California do that? No, they can’t. They tried to, a number of years ago, and in response Congress passed a law making it illegal for a state to tax retirement plan distributions to residents of another state, even if the non-resident had earned the contributions while living and working in the taxing state. This law applies to tax-favored retirement accounts, like IRA’s and 401(k)’s, but it doesn’t apply to many non-qualified deferred compensation plans.

(What’s a non-qualified deferred compensation plan? It’s a kind of retirement plan only available to highly paid employees. If you’ve got one, you know what it is.)

So as you do your planning, and project your tax costs, pay a bit of attention to your state’s taxing scheme.