;

Avoiding State Income Tax on Retirement Plan Distributions

When a retiree begins taking distributions from a traditional IRA, 401(k), or pension plan, those distributions are taxable to the retiree under federal income tax and any applicable state income tax rules. While federal taxation cannot be avoided, state taxation may be avoided depending on your state of residency. In general, there are some states that have zero income tax and therefore don’t tax retirement plan distributions, some states that have special exemptions for retirement plan distributions, and other states that do in fact tax retirement plan distributions. This article breaks down the basics and discusses some of the states where income taxes can be avoided.

The No State Income Tax States

First, the easiest way to avoid state income tax on retirement plan distributions is to establish residency in a state that has no state income tax. It isn’t just the fun and sun of Florida that helps attract all of those retirees. It’s the tax free state income treatment that you’ll get from all of that money stocked away in your retirement account. The other states with no income tax and therefore no tax on retirement plan distributions are Alaska, Nevada, South Dakota, Texas, Washington, and Wyoming.

States with Retirement Income Exclusions

Second, there are some states that have a state income tax but who exempt retirement plan distributions for retirees from state income taxes. There are 36 states in this category that have some sort of exemption for retirement plan distributions. As each of these states are very different, so too are their exemptions. The type of retirement account, however, does tend to govern the exemptions available. Here’s a quick summary of the common exemptions found in the states.

  1. For Public Pensions and Retirement Plans. Distributions from federal or state employer plans are exempt from taxation in many states. This is the most common exemption amongst states that have an income tax but who exempt some types of retirement plan distributions from income. Most of the 36 states that have an exemption for retirement plan income provide an exemption for public employee pensions and retirement plans.
  2. For Private Pensions and Retirement Plans. About 10 states offer a full exclusion for private pensions and retirement plans. Some of them differ between pension and contributory plans (e.g. 401(k)) and some of them make no distinction. Pennsylvania, for example, excludes all income distributions. Hawaii excludes certain distributions from state income tax for private retirement plans and for portions from company plans rolled over to a rollover IRA and then distributed from the rollover IRA.
  3. For IRAs. There are some states that do no tax any retirement pan distributions, including IRA distributions to retirees. Illinois for example does not tax distributions from retirement plans at all (pensions, IRAs, 401(k) s). Tennessee and New Hampshire are states that do not tax wage income and therefore they do not tax retirement plan distributions of any kind (IRA, 401(k), etc.). There are also numerous states that exclude a certain limit of retirement plan income from taxation. For example, Main exempts the first $10,000 of income from any retirement plan, including IRAs.

In sum, the state tax rules for retirement plan distributions are complicated and vary significantly. Each state can be understood rather quickly though and everyone planning for retirement should understand how state income taxes may eat into their planned retirement plan distributions. I, for example, looked into Arizona and found that there is no exemption for 401(k) or IRA income in the state of Arizona. While we do have a low state income tax rate, Arizona state income tax includes income from private retirement plans (pensions and 401(k) s) and IRAs and has a modest deduction for distributions from public retirement plans. Each state is unique to the type of plan, and the amounts being distributed but don’t just think you need to be in a state with zero income tax to avoid taxes on retirement plan distributions. For example, you could be in Illinois, Tennessee, or New Hampshire and could realize state income tax-free distributions of your IRA or 401(k).  The National Conference of State Legislators has an updated 2015 chart that is very useful and can be used to look up your state’s tax treatment of retirement plan distributions for retirees.

Tax Court Rules Against Self-Directed IRA Owner Who Failed to Properly Make a Real Estate Investment

In a recent U.S. Tax Court case, the Court ruled against an IRA owner and deemed his IRA distributed and taxable as the IRA owner failed to properly execute his intended self-directed IRA real estate investment. Dabney v. Commissioner, T.C. Memo 2014-108.

The IRA owner had an IRA at Charles Schwab and intended to use the IRA to acquire real estate in Brian Head, UT. Upon conducting research Mr. Dabney learned that an IRA could own real estate. However, instead of rolling or transferring his IRA funds to a self directed IRA custodian who would allow his IRA to own real estate, Mr. Dabney took a distribution of the IRA and directed Schwab to wire the funds to closing for the purchase of the property. Additionally, he instructed title and eventually received a deed in the name of his Schwab IRA.

The problem was that rather than invest his IRA into real estate he instead distributed his IRA and use the distributed fund to buy real estate outside of his IRA. Charles Schwab issued Mr. Dabney a 1099-R for that distribution and Mr. Dabney contested the 1099-R and the taxes owed as a result arguing that the funds were used to buy a property owned by his Schwab IRA. Mr. Dabney argued that Charles Schwab made a mistake. However, the Court ruled against him because his funds were distributed out of his Charles Schwab IRA and because his IRA funds and the real estate were not held by a self-directed IRA custodian that allowed for IRAs to own real estate. The Court stated that an IRA can certainly hold real estate but that Charles Schwab’s policies did not allow for Mr. Dabney’s IRA to own real estate and since his custodian would not hold the real estate as an asset of his IRA that it was deemed distributed.

The lesson to be learned from the Dabney case is that in order to properly execute a self-directed IRA investment into an asset such as real estate, the IRA owner needs to roll over or transfer their IRA funds first to a self-directed IRA custodian who allows the IRA to own real estate and then that self-directed IRA will actually take title and ownership to the IRA asset directly. While these rules seem simple, I’d estimate that I speak to at least one or two IRA owners a year who took a distribution from an IRA and used those funds to buy real estate (or some other alternative asset) thinking that the real estate would still be owned by their IRA and that the funds would not be distributed and subject to tax. The confusion usually arises with the non-self directed custodian who misunderstands what the the account owner is trying to do (invest the IRA, not distribute it). Keep in mind, that in order to own real estate with a self-directed IRA, you must have a self-directed IRA custodian.