By Mark H. Levin, CPA, H.J. Behrman & Company LLP

Recent amendments to IRC sections 457 and 3401 changed the characteristic of distributions from a government section 457 deferred compensation plan, from payment as wages to payment as a pension or annuity. This change affects only government section 457 plans; distributions from nongovernment section 457 plans remain characterized as wages. These amendments also now permit a tax-free trustee-to-trustee transfer between these government plans and other qualified plans and traditional IRAs. These changes were effective for tax years beginning on or after January 1, 2002.

The following summaries are relevant to individuals, estates, and trusts in the indicated municipal categories.

New York State, New York City, and Yonkers Residents

Because New York State Tax Law conforms to the federal characterization of income, the federal change is reflected in the New York treatment of these distributions. Under prior law, distributions from any section 457 plan were characterized as wages, and were not eligible for the $20,000 exclusion (for taxpayers
59 Aw or older) [Tax Law 612(c)(3-a)]. Under the amended sections, distributions from a government section 457 plan are now considered pension and annuity income, and are eligible for this exclusion. Only periodic payments are so eligible; lump-sum payments are not. Participants in these plans contemplating taking a lump-sum distribution should make a tax-free rollover of the amount into a traditional IRA first, then take the lump-sum distribution from the IRA. This
permits the eligible taxpayer to take advantage of the $20,000 exclusion, because nonperiodic distributions from IRAs qualify.

New York State

Nonresidents. U.S. Code Title 4, section 114, prohibits the taxation of nonresidents on income from IRC section 457 plans. Because this is not considered income from New York sources, it is excluded from the numerator of the income percentage and the $20,000 exclusion may not be claimed against any New York–source income. Nevertheless, section 457 plan income is included in the denominator of the income percentage, so the $20,000 exclusion may be utilized against that income, as if a resident.

Part-year residents. While a New York State part-year individual resident, estate, or trust computes its income in the same manner as a resident, it must also compute income from New York sources. In this computation, a part-year resident must include any section 457 plan income earned while resident; that which is earned while nonresident is not included as New York–source income. It should be noted, however, that if a part-year resident had the unrestricted right to receive the income while a resident, the accrual rules of Tax Law section 639 require that the taxpayer include that income in the New York–source income computation. Part-year residents may exclude up to $20,000 of section 457 plan income received or accrued during the resident period.

New York City

Nonresidents. Because the New York City nonresident earnings tax has been repealed, receipt of section 457 income by a nonresident is not taxable.

Part-year residents. Because New York City income tax on part-year residents is computed on New York City–source income, section 457 income earned while a resident is included. Any section 457 income earned while a nonresident is not included in the New York City–source income computation. If a part-year resident had the unrestricted right to receive the income while a resident, however, the accrual rules of Tax Law section 639 require that the taxpayer include that income in the computation. A part-year resident may exclude up to $20,000 of section 457 plan income received or accrued when a resident.

Yonkers

Residents. Because Yonkers tax is computed as a surcharge on New York State tax, any section 457 income and its attendant exclusion has been taken into account in the Yonkers resident tax computation.

Nonresidents. Yonkers taxes nonresidents on self-employment earned within the city. Because distributions from section 457 plans are now characterized as pension and annuity income, they are not considered self-employment income and thus are not subject to the Yonkers nonresident earnings tax.

Part-year residents. The Yonkers “surcharge” tax is computed for part-year residents as follows:

If a part-year resident had the unrestricted right to receive the income while a resident, the accrual rules of Tax Law section 639 require the taxpayer to include that income in the computation of New York–source income for the Yonkers residence period.