NEW FEDERAL LAW PROHIBITS STATE TAXATION OF NONRESIDENTS'
RETIREMENT INCOME

By Paul R. Comeau, Mark S. Klein, and Sharon M. Kelly

Work hard, retire to Florida, and enjoy the fruits of your labor free from New York income tax. Many former New York residents retired to warmer and tax-friendlier climes with that dream, only to be rudely awakened when the New York State Department of Taxation and Finance tracked them down in their retirement havens and assessed tax on their pension benefits, IRA distributions, and other retirement income.

For 1996 and future years, the Federal government has provided significant relief to pensioners in this predicament. A new law signed by President Clinton on January 10, 1996, states: "No State may impose an income tax on any retirement income of an individual who is not a resident or domiciliary of such State (as determined under the laws of such State)." The new law covers both "qualified" and certain nonqualified plans. It applies to benefits received after December 31, 1995.

Qualified Plans

The law specifically covers income received from the following types of qualified plans:

1. An employer plan qualified under IRC section 401(a), including defined benefit plans, defined contribution plans, 401(k) plans, profit sharing plans, Keogh plans, etc.;

2. A simplified employee pension (SEP) defined in IRC section 408(k);

3. An annuity contract purchased by an employer under a plan qualified under IRC section 403(a);

4. An annuity contract described in IRC section 403(b) that is purchased by an employer for employees of a tax exempt [501(c)(3)] organization or by a governmental employer for employees of schools and educational organizations;

5. An IRA described in IRC sections 408(a) and 408(b);

6. A deferred compensation plan established by a state or local government or tax exempt organization that is qualified under IRC section 457;

7. An employee plan established by Federal or state government, a political subdivision of a state, or an agency or instrumentality of such a government, as defined in IRC section 414(d);

8. A trust created before June 25, 1959, under a pension plan funded only by employee contributions, as defined in IRC section 501(c)(18).

Nonqualified Plans

The new law also prevents states from taxing income that nonresidents receive from nonqualified plans, as long as the plans meet certain requirements:

1. The benefits must be paid from a plan, program, or arrangement that satisfies the definition of a "nonqualified deferred compensation plan" under IRC section 3121 (v)(2)(C); and

2. The benefits must satisfy (a) or (b) below:

(a) income is part of a series of substantially equal periodic payments, payable at least annually, over the life or life expectancy of the recipient, the joint lives or life expectancies of the recipient and a designated beneficiary, or a period of al least 10 years; or

(b) income is received after employment has terminated under an employment-related plan maintained solely to provide benefits to employees in excess of certain IRC restrictions on qualified plan contributions or benefits [IRC sections 401(a)(17), 401(k), 401(m), 402(g), 403(b), 408(k), 415, and any other IRC limitations on plans to which these sections apply].

Nonqualified Deferred Compensation Plan. IRC section 3121(v)(2)(C) defines a "nonqualified deferred compensation plan" as any plan for deferring compensation into a later year, other than specified qualified plans. On January 19, 1996, just after the new law was passed, the Treasury Department released a long-awaited regulation on IRC section 3121(v)(2). The proposed regulation provides some restrictions on the statute's broad definition. In particular, it excludes a plan that provides benefits "in connection with impending termination of employment." If the recipient of benefits leaves employment within 12 months of the date the plan is established, and if facts and circumstances indicate that the plan was established in contemplation of that impending termination, the benefits will not be protected from state taxation under the new law. To qualify, deferred compensation arrangements must be established under a written plan more than twelve months before the beneficiary leaves employment and begins to receive benefits under the plan.

Substantially Equal Periodic Payments. The new law does not define this phrase. The same term, however, is used in IRC section 72(t) dealing with early distribution penalty taxes. In that connection, the term has been deemed to include amounts determined using the minimum distribution calculation, amounts determined by amortization over the payout period using a reasonable interest rate, or amounts determined by dividing the account balance by a reasonable annuity factor.

Discussion and Comparison with
New York Rules

Although the law prohibits taxation of "retirement income," there is no requirement that the individual actually be retired for the law to apply. The term "retirement income" is defined in the statute as any income from one of the qualified or nonqualified plans described above. Consequently, the law will protect an individual who is still employed and receives a distribution from an IRA or a hardship distribution from a 401(k) plan. The only part of the law that requires actual termination of employment is the portion governing distributions from nonqualified deferred compensation plans maintained solely for the purpose of providing benefits in excess of certain IRC limitations.

Although the new Federal law will benefit many nonresident retirees, there are certain situations where the law does not apply. In these circumstances, existing New York provisions on pension income may allow partial or total exclusion of retirement benefits from a nonresident's New York source income.

Prior to the enactment of the new Federal law, New Yorkers who left the state could sometimes protect their retirement income from New York taxation using a special exemption known as the "annuity rule." Under this regulatory provision, pension and other retirement benefits received by a nonresident are not treated as New York source income as long as they are 1) paid under a written employer-employee agreement; 2) paid in money; 3) paid at regular intervals (at least annually); 4) paid at a constant rate, at a rate that varies only with a standard cost-of-living index, market performance of plan assets, or commencement of Social Security benefits, or in a manner where the total distribution amount can be determined when benefit payments begin, and 5) paid for life or over a period that is at least one-half of the recipient's life expectancy as of the annuity starting date.

While the annuity rule was helpful in some situations, it did not protect retirees who took lump sum distributions or benefits payable over a period shorter than one-half their life expectancy. It did not apply to IRC section 457 plans and, significantly, it did not apply to IRAs. Individuals who took lump sum distributions from their pension plan and rolled the money into IRAs lost their ability to qualify for the annuity exemption, even though their IRA distributions otherwise met the annuity rule requirements. The new Federal law applies to both IRAs and IRC section 457 plans, as well as lump sum distributions from qualified plans. It therefore provides much broader protection to nonresidents than the annuity rule did.

New York's annuity rule remains in place and can still be useful in some situations involving nonqualified plans. For example, deferred compensation plans that were put into place on the eve of the beneficiary's retirement may not satisfy the 12-month requirement under IRC section 3121(v)(2)(C). If such plans meet the requirements of the annuity rule, however, benefits paid under them can still be excluded from New York source income. The annuity rule could also apply where benefits are paid from a nonqualified plan over a period that is less than 10 years (and therefore not eligible for the Federal exclusion) but more than one-half the life expectancy of the recipient. Since IRS tables list the life expectancy of a 65-year-old as 20 years, anyone aged 66 or more has a half-expectancy that is less than 10 years, allowing shorter payout periods.

Other New York exceptions continue to apply, even to benefits that do not qualify for Federal protection. Individuals over age 591/2 are still entitled to a $20,000 exclusion for pension and retirement benefits. Workers whose retirement benefits are attributable to services performed both within and without New York can continue to use New York's special allocation rule even if their benefits do not qualify under the Federal rule (e.g., a lump sum distribution from a nonqualified plan). Under this rule, the New York "piece" of a benefit is determined using a ratio of New York compensation over total compensation in the year of retirement or termination and the three preceding years.

The long-term effect and fate of the new Federal law prohibiting state taxation of nonresident retirement benefits have not yet been determined. Suits by individual states are possible, claiming that the law unconstitutionally infringes state rights. States may also amend their own laws to allow present taxation of retirement plan contributions rather than following the Federal rule of deferring tax until receipt. New York already has in its arsenal an "accrual rule" that imposes tax on future, determinable income at the time an individual becomes a nonresident of the state. New York has generally refrained from using this provision to tax deferred compensation, but that could change in light of the new Federal rule. For the time being, however, nonresidents have the benefit of the broad protection provided under Federal law. *

Paul R. Comeau and Mark S. Klein are partners and Sharon M. Kelly is an associate in the Buffalo Office of the law firm of Hodgson, Russ, Andrews, Woods & Goodyear, LLP. Each is a member of the firm's New York State Tax Practice Group.

State and Local Editor:
Marshall L. Fineman, CPA
David Berdon & Co. LLP

Interstate Editor:
Stuart A. Rosenblatt, CPA
Wiss & Company LLP

Contributing Editors:
Henry Goldwasser, CPA
M. R. Weiser & Co LLP

Leonard DiMeglio, CPA
Coopers & Lybrand L.L.P.

Steven M. Kaplan, CPA
Konigsberg Wolf & Co., PC

John J. Fielding, CPA
Price Waterhouse LLP

Warren Weinstock, CPA
Paneth Haber & Zimmerman LLP