New Federal Law Prohibits State Taxation of Nonresidents' Retirement Income

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Work hard, retire to Florida, and enjoy the fruits of your labor free from New York income free 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(cX3)] 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 (vX2)(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(vX2)(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 estabfished, 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. …