New Law Prevents States From Taxing Retiree Income Across State Lines

Ideas for Individuals -- February 1997 Issue

President Clinton recently signed a new law, effective January 1, 1996, prohibiting states from taxing most retirement income of their former residents. The so-called "source tax" on pension plan distributions had become a popular method for states with high income tax rates to tax pension income received by employees who had worked for an employer in the taxing state but who lived in another state after retirement. For example, New York State would tax a former New York resident who had moved to Florida, or a New Jersey resident who had worked in New York, on pension income received from a New York employer.

What Does The New Law Protect?

The new law prevents states from taxing all pension income or retirement distributions received by nonresidents from qualified retirement plans including:

1. pension plans, profit-sharing plans and stock bonus plans;
2. simplified employee pension plans;
3. qualified annuity plans;
4. annuity contracts of tax-exempt organizations;
5. individual retirements accounts;
6. deferred compensation plans of tax-exempt organizations; and
7. government retirement plans.

The new law also protects payments from two types of nonqualified plans that are often used by executives to defer compensation. First, distributions made from nonqualified deferred compensation plans would be exempt if the payments are part of a series of substantially equal periodic payments made at least annually and are made over a period of (i) at least ten years or (ii) the life expectancy of the recipient. Second, payments received from "excess benefit" and "supplemental retirement" plans also are exempt from source taxation. These are plans that provide nonqualified retirement benefits to employees in excess of the benefits that may be provided under qualified retirement plans because of the $150,000 compensation limitation and various other limitations imposed on qualified plan benefits under the Internal Revenue Code.

The new limitation on state source taxation will be a welcome relief for many taxpayers who have left or intend to leave New York, California or other states with high income tax rates to retire in Florida, Nevada or other states with low income tax rates. However, it is important that nonqualified deferred compensation arrangements be properly structured if the payments are to qualify for exemption under the new law.

For more information, please contact Steven B. Katz or Kirk H. O'Ferrall.