Don't double pay state taxes on IRA and 401(k) retirement accounts

Karin Price Mueller for the Star Ledger writes: Question. How do state taxes work on withdrawals from IRA and 401(k) accounts? Presently, unlike my federal taxes, New Jersey does not recognize any tax breaks on my contributions to my IRA or 401(k) accounts, therefore, I am paying taxes on this money. If I still live here when I retire, I assume all my withdrawals from these accounts have zero New Jersey state taxes owed, correct? What happens if I retire to a different state? Do I pay that state’s taxes on the same withdrawals, and, if so, then I’m paying taxes on this money twice, right?

— JB

Answer. As your question shows, the taxation of retirement account withdrawals can be confusing.

The IRS allows you to deduct contributions to an IRA (assuming you meet eligibility rules), but the New Jersey Gross Income Tax Act does not contain similar provisions.
“When you make a withdrawal from an IRA, the amount you contributed is not taxable,” said Bernie Kiely, a certified financial planner and certified public accountant with Kiely Capital Management in Morristown. “The earnings on your original contributions are taxable when withdrawn.”

In tax talk, your contributions are called “basis.” You must keep track of your basis as long as you have the IRA, Kiely said.

In New Jersey, contributions to a regular 401(k) plan are exempt from income in the year contributed. Therefore, Kiely said, you have no basis in your 401(k) plan, so withdrawals are fully taxable. If you make nondeductible contributions to your IRA, these contributions do have basis.

Kiely offered this example: Let’s assume you retired and rolled your 401(k) plan into a traditional IRA account and you are now beginning to make withdrawals. If withdrawals from a traditional IRA are made over a period of years, the portion of the distribution that represents interest and accumulated gains (including amounts rolled over and not previously taxed) must be reported as taxable income each year a withdrawal is made. The amount subject to tax is based on the ratio of the taxable portion to the amount in the account.

“If you had $150,000 in the account and your basis — nondeductible contributions — was $12,000, then your taxable amount would be $138,000 or 92 percent,” he said. “If you withdrew $10,000 from the account, the taxable amount would be $9,200 — 92 percent — and the nontaxable portion would be $800 — 8 percent.”

The next year, your basis would be $11,200 ($12,000 - $800), he said, and you’d redo the calculation each year.

That’s why it is so important to keep track of your cost basis.

Kiely said the amount of an IRA distribution taxable to New Jersey is based on the amount you withdrew while you were a New Jersey resident. If you moved out of New Jersey, you should immediately notify your IRA custodian that you moved.