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Hard Choices on Taxing or Not Taxing Pension Income

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By Lowell L. Kalapa

Another Tax Review Commission is currently undertaking a periodic review of the state’s tax system with respect to tax and revenue policy and they will be faced with the growing disparity in the treatment of retirement income under the state’s income tax law.
Under current law, traditional pension income granted in the form of compensation for past services is excluded from the tax base for state income tax purposes. These are benefits which are usually received in the form of the traditional defined benefit type of plans where the employer (and sometimes the employee) makes payments based on current salary to a plan which then computes the benefit on the number of years and the amount contributed to the plan as is the case with the public employees’ retirement system.
However, with the advent of a number of ways to save for retirement designed largely by federal law to encourage a variety of ways to provide for after career income, there will be a growing disparity between how the state income tax law treats those benefits and the benefits of the traditional defined benefit pension plan. These include distributions or benefits from what is known as 401(k) plans, SEPS’s, and 403(b) and 457 plans, the latter of which are types of deferred compensation plans. The former two are basically savings plans designed specifically to replace or substitute as pension income plans.
These alternative methods of providing for pension income are currently taxable under the state income tax as they are all viewed as “deferred compensation” as opposed to “payment for past services.” As a result, as more and more workers begin to retire with these types of plans as their means of livelihood in their golden years, they will have to pay state income taxes on their retirement income while those who are beneficiaries of the traditional types of pensions will not.
Up until now the issue of taxing pension income has been one to tiptoe around because imposing a tax on what has been exempt from taxation is a difficult issue to discuss without raising a hornet’s nest of outcry. That was the response when the 1985 Tax Review Commission made such a proposal.
Some ask why not exempt all income paid as retirement income? That might be the simple solution until one considers that as the “baby boomers” begin to age and retire, the ratio of those in the active workforce and those who will be retired will begin to shift with those in retirement becoming a larger percentage.
That being the case, exempting basically what would be retirement income would shrink the size of the base subject to the income tax. Unless government services also shrink, there will be insufficient revenues generated from the net income tax.
So the challenge to the Tax Review Commission and lawmakers in the coming years is what to do about the disparity between the different types of retirement income, some of which are currently exempt and others which are not. In the interest of preserving horizontal equity, that is treating all taxpayers who are in the same situation alike; either all retirement income should be taxed or all retirement income should be exempt.
If the choice is to exempt all retirement income, then the Commission must address the issue of shrinking the net income tax base and how the lost revenues are to be addressed. If, on the other hand, the choice is to begin taxing all “retirement income,” then both the Commission and lawmakers must deal with the potential backlash from those taxpayers who currently enjoy this exemption.
If the choice is to start taxing retirement income of all sorts, there are a variety of responses that might mitigate some of the protests. One might be to adopt a prospective effective date as to when the state would begin taxing all retirement income, say ten or fifteen years from the date the action is adopted. This would assure those who are currently receiving exempt pension income that the taxing of that income would not occur for a number of years into the future.
Another consideration would be to set a larger floor for this particular type of income before the net income tax rates would be imposed. This approach would be similar to the way the federal government taxes high income beneficiaries of Social Security.
Regardless, both the Tax Review Commission and lawmakers will have to address this thorny issue in the very near future as the population begins to age and retire.

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