More On Tax Planningfrom The Advisor's Professional Library
- IRAs: In General Individual Retirement Accounts are highly popular tools for contributing funds that grow on a tax deferred basis. Depending on the type of IRA, the accumulation can be tax free.
- Annuities: Estate Tax The value of certain types of annuities may be included in an estate’s value. Understanding the intricacies of these inclusions is a critically important aspect of estate planning.
For many clients today, post-retirement relocation has become the ultimate goal. Unfortunately, these clients have often failed to consider the state tax implications that may arise when they tap into retirement funds in a new state—a state in which the funds were not actually earned. This type of scenario could result in the client becoming subject to taxation in both the state in which the income was received and the state in which the income was earned—even though the client has relocated—especially in the case of funds received pursuant to a nonqualified deferred compensation plan. With careful planning, however, the client may be able to use federal rules to avoid taxation in the state where the income was earned, preventing unnecessary double taxation at the state level.
The Federal Source Tax Law
The federal source tax rules prevent a state from taxing certain types of retirement income received by clients who are no longer residents of that state solely on the basis that the income was earned in the taxing state. Under the source tax rules, a state is not permitted to tax nonresidents on income received from qualified pension plans, profit-sharing plans and stock bonus plans, IRAs, simplified employee pension plans and other similar types of qualified plans, even though the funds contributed to the plan were earned in the taxing state.
Therefore, if a client funds an IRA with income earned in New York (which would be subject to New York state income tax if it had been received rather than placed into a tax-deferred vehicle) and later moves to Florida (a state with no income tax), the funds will escape taxation at the state level entirely under the federal source tax rules.
However, because the IRS places dollar limits on contributions to these types of qualified plans, many high-income clients may receive funds from nonqualified deferred compensation arrangements sponsored by their employers.
Planning for Nonqualified Deferred Comp Arrangements
Though the source tax rules protect certain income received pursuant to a nonqualified deferred compensation arrangement, clients must be much more careful in structuring receipt of this income so as to avoid taxation in both the current and prior state of residence.
In order to be protected under the federal rules, distributions from a nonqualified deferred compensation plan must be made in a series of substantially equal periodic payments (made at least annually) either for the life expectancy (or joint life expectancy of the client and a beneficiary) or over a period of at least 10 years.
Further, funds received pursuant to a nonqualified deferred compensation arrangement are sheltered by the source tax rules if the arrangement is structured as an excess benefit plan, even if the funds are received in a lump sum. Funds are received from an excess benefit plan, and are thus protected from double state taxation, if they are paid out after the client terminates employment as long as the plan is maintained by the employer solely to provide retirement benefits in excess of the limitations required by the Internal Revenue Code (such as the compensation and contribution limits imposed upon qualified plans).
Importantly, if an excess benefit plan is combined with a plan that allows for income deferral based upon factors other than providing excess retirement benefits, the funds may be subject to double state taxation if they are received in a lump sum payment.
The federal source tax rules can typically be used to prevent double state taxation of retirement funds received under a tax-qualified arrangement. However, because funds from nonqualified deferred compensation arrangements are protected from double state taxation only in limited circumstances, it is important that your clients plan so that these payments do not become subject to unnecessary taxation in a state where the client no longer resides.
See also 9 Tax Breaks Expiring at Year’s End.
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