The taxation of retirement income from Individual Retirement Accounts (IRAs) raises many concerns to individual taxpayers, such as naming a beneficiary, whether to convert some or all IRA holdings to Roth IRA holdings, in which state to retire, and the tax consequences of the IRA distributions. When considering the tax consequences, most individuals focus their attention on federal income tax issues, which can be daunting in their own right. Yet it’s the state income tax issues that are sometimes even more challenging, especially if the IRA owner moves to a new state to retire or if the owner dies and the beneficiary has an inherited IRA. Let’s take a look at a few situations to better understand some of the challenges confronted by an IRA owner or beneficiary.
RELOCATION CHALLENGES
One challenge involves moving to another state and beginning or continuing to take distributions from an IRA. The IRA owner faces the challenge of claiming some or all of the distribution on his or her federal and state income tax returns. The taxability of an IRA distribution at the federal level doesn’t change as a result of the move, but the taxability of that same amount is more than likely going to change at the state level. States, as we know, tend to tax retirement income differently.
Many states provide a pension exclusion for the taxable portion of retirement income, which includes pensions, 401(k)s, and even traditional IRAs. The amount and eligibility requirements, however, will vary across states that have an income tax. Pennsylvania has a state income tax, but it excludes 100% of an IRA distribution if the distribution is made on or after the taxpayer’s retirement age (i.e., 59½) or if the taxpayer receives annuity income [61 PA Code §101.6(c)(8)]. South Carolina provides a two-tier pension exclusion. A taxpayer under age 65 is eligible to exclude up to $3,000 annually per spouse. If the taxpayer is 65 or older, he or she is eligible to exclude up to $10,000 annually per spouse [S.C. Code Ann. §12-6-1170].
Wisconsin provides a phased-out exemption for up to $5,000 of certain retirement income if the taxpayer is age 65 or older on December 31 and has federal Adjusted Gross Income (AGI) less than $15,000 (or $30,000 if married, filing jointly). In addition, the Wisconsin exemption applies to each spouse; thus, if both spouses qualify and have taxable income from a qualified retirement plan or an IRA, then up to $10,000 may be excluded on a joint return [Wis. Stat. §71.05(1)(ae)].
A few states provide help for new residents. A taxpayer who moves into the state is given the ability to adjust his or her basis in the IRA for amounts contributed while a nonresident. For example, Oregon and Virginia [Virginia Code §58.1-322.C.19] permit such an adjustment for contributions to a plan that have already been taxed by another state—though Oregon allows the subtraction only if several conditions are satisfied [Or. Rev. Stat. §316.159(1); Or. Admin. R. 150-316.159].
BENEFICIARY CHALLENGES
Federal tax law requires a person who inherits an IRA to take distributions from that IRA. As a result, the taxable income becomes includible in the beneficiary’s state gross income in the same year. The rules for a beneficiary can be good or bad depending on the state and the situation. New York, for example, permits a taxpayer to claim a pension exclusion of up to $20,000 annually if the taxpayer is age 59½ or older. Better yet, New York permits a beneficiary to claim the same pension exclusion if the deceased owner would be eligible to claim the exclusion had he or she lived. Thus, the controlling issue is the age of the owner and not the beneficiary. See, for example, New York State Department of Taxation and Finance Publication 36, “General Information for Senior Citizens and Retired Persons,” March 2015, pp. 14-16.
New York also addressed the issue of multiple beneficiaries and the availability of the pension exclusion. Specifically, if the deceased individual has more than one beneficiary, the $20,000 maximum amount of the pension and annuity exclusion must be allocated among the beneficiaries. That would mean that each beneficiary’s share of the $20,000 exclusion is determined by multiplying the $20,000 by a fraction whose numerator is the value of the pensions and annuities inherited by the beneficiary and whose denominator is the total value inherited by all beneficiaries of the deceased individual’s pensions and annuities.
Pennsylvania, as already noted, excludes the entire federally taxable retirement income if the owner is 59½ or older. The exclusion extends to distributions from an IRA if the payments are paid to the estate or designated beneficiary of the participant by reason of the participant’s death. (See Section 10 of the Pennsylvania Department of Revenue Personal Income Tax Bulletin 2008-1, January 16, 2008.) Therefore, the age of the beneficiary isn’t a relevant factor in Pennsylvania.
In the case of a surviving spouse who has an inherited IRA, the exclusion doesn’t apply if the surviving spouse elects to take ownership of the IRA assets. The surviving spouse would need to reach the age of 59½ before withdrawing any funds from the IRA to qualify for the exemption.
Maryland provides a pension exclusion for taxpayers age 65 or older. But its pension exclusion isn’t extended to distributions from a traditional IRA, Roth IRA, a simplified employee plan (SEP), or a Keogh [Maryland State Tax Reporter §10-209(a)(2)]. Therefore, distributions from an IRA or inherited IRA are totally includible in Maryland’s gross income.
ROTH IRA CHALLENGES
Distributions from a Roth IRA are totally excludible from both federal and state income taxes if the owner satisfies the plan’s longevity criteria (the owner has had a Roth IRA for at least five years) and one of the other criteria (is at least age 59½, has died, or has a disability). For an inherited Roth IRA, the only time a beneficiary would have a taxable Roth IRA distribution is if the deceased owner didn’t have the Roth IRA for more than five years. And even in this rare situation, the ordering rules for a Roth IRA would distribute the investment portion first before the earnings portion. So if the beneficiary distributed the asset before the end of the fifth year, the Roth IRA would more than likely have satisfied the five-year criteria. See, for example, Jo Ann Lippe and Anthony P. Curatola’s book, Individual Retirement Account Answer Book, 22nd edition, published by Wolters Kluwer Law & Business.
When planning estate matters, it’s important to consider the state income tax effect of IRAs for the beneficiaries. As you can see, the state income tax issues may be more challenging than the federal rules.
© 2016 A.P. Curatola
July 2016
