GEORGETTE JASEN for the Wall St Journal writes: Most investors know that withdrawals from traditional individual retirement accounts and other tax-deferred retirement plans are generally taxable on the federal level. But unless they live in one of the seven states without a state income tax (Alaska, Florida, Nevada, South Dakota, Texas, Washington state and Wyoming), they may assume they will also be taxed on the state level.
Happily, that isn't always the case.
Some states don't tax retirement-account withdrawals at all, and others exempt a partial amount from taxation, sometimes only for retirees above a certain age or with income below certain thresholds. It generally depends on the state you live in when you take the distributions, but it can get confusing.
"It's quite a mishmash out there," says Jeffrey Levine, a CPA specializing in IRA taxation at Ed Slott & Co. "You have to keep careful records, and it's important to understand the rules of the state you're in."
Here are some things you need to know, even if you're years away from retirement.
When are federally taxable withdrawals not subject to state tax?
Unlike the U.S. tax code, which allows many taxpayers to deduct IRA contributions up to a certain amount, some states don't allow those deductions on state tax returns. The trade-off: Those states generally don't tax at least a portion of the withdrawals. But how much of the withdrawal is exempt from taxation depends on the state. Pennsylvania doesn't tax any retirement income, including Social Security and pensions, although it limits the exemption to taxpayers older than 59½. New Jersey also excludes Social Security benefits from taxation and exempts up to $15,000 of retirement-account withdrawals and pension income for single taxpayers and $20,000 for married couples filing jointly if total income is less than $100,000 and they're older than 62.
There also are tax breaks on withdrawals in some states that do permit deductions for IRA contributions. In Illinois, most retirement income is exempt from taxation, including withdrawals from IRAs, 401(k)s, pensions and Social Security benefits. New York exempts from taxation the first $20,000 of retirement-plan withdrawals for taxpayers older than 59½.
Keep in mind that tax breaks may be subject to change, especially in states facing big deficits after the financial crisis, says Kathleen Thies, a state tax analyst at CCH Inc., a unit of Wolters Kluwer NV that provides tax information and services. "Those states need to make up the deficits somehow."
What is "basis," and how do I calculate it?
Basis generally refers to the cost of an investment and is used to calculate the income subject to tax. In the case of retirement plans, basis typically refers to the amount of any after-tax contributions.
Thus, for federal purposes, the basis for contributions to a tax-deductible IRA would be zero and the full amount of a withdrawal would be taxable. But there would be basis for state tax when there was no deduction.
In New Jersey, for example, it works like this: Let's say you have $400,000 in an IRA when you retire, including $100,000 in nondeductible contributions and $300,000 of earnings. The nondeductible contributions would be your basis and 75% of a distribution could be taxable.
Many mutual-fund companies and other financial institutions will withhold state taxes if requested, and some states require such withholding. Financial institutions holding retirement-plan assets generally can tell you the amount contributed after tax, which is your basis. This, along with how much of a withdrawal is subject to state tax and how much was withheld, may be reported on the 1099R form you receive in connection with distributions from pensions, annuities, IRAs and other retirement plans. Still, it's always a good idea to keep your own records.
States generally follow the federal model for 401(k) distributions so you won't have basis in those distributions for state-tax purposes, unless you made after-tax contributions. This can get complicated if you have made both pretax and after-tax contributions. "It's all about record-keeping," says Michael Steiner, a wealth adviser at RegentAtlantic Capital, Morristown, N.J. "A lot of people may not have the documentation."
What happens if I move to a state with a different set of rules on retirement-account
taxation?
Under federal law, you are taxed in the state in which you reside. But you may have to prove residency with a new drivers' license or voter registration, and if you move during the course of the year you may have to file partial-year returns to one or both states.
"It's best to make a clean break," says Robert Barbetti, a retirement specialist at J.P. Morgan Private Bank, a unit of J.P. Morgan Chase & Co. "I usually tell people to move at the beginning of the year, if possible."
Some of those who move may find themselves in the happy situation of having had a deduction for their IRA contributions but paying no tax on withdrawals. Of course, the opposite could also be true: Your contribution was made with after-tax income but withdrawals may be fully taxed, depending on the state.
Remember there are other tax issues to consider when contemplating a move. Many states that tax IRA distributions don't tax Social Security and other pension income. Estate-tax, property-tax and sales-tax rates also can vary greatly.
What's the state-tax treatment of rollovers from 401(k)s to IRAs?
Many who take a lump sum from their 401(k) plan when they retire roll it over into an IRA within 60 days, which isn't taxable on federal or state returns. If all contributions were pretax, withdrawals from those IRAs would have zero basis for federal and state tax purposes.
You may want to spread the payouts over a number of years to minimize the tax bite, or if you plan to move to a state offering more favorable tax treatment for retirees, wait until you move to take withdrawals.
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