Don’t Overlook State Income Tax Exemptions for Certain Retirement Plan Payouts

Recently, we’ve received several phone calls and email inquiries from CPAs, and from a corporate officer who is retiring from one of our clients, regarding which forms of retirement payments are exempt from Alabama income tax, particularly if the client intends to move away from Alabama upon retirement. As you get closer to busy season, you too may be asked a similar question.

We all know Alabama’s schizophrenic rules regarding payments from qualified defined contribution (i.e., profit-sharing) or defined benefit ( i.e., pension) plans, but there are a variety of other deferred compensation plans out there that aren’t considered “qualified” under the Internal Revenue Code. As the former Administrative Law Division ruled in Hensley vs. State Dep’t of Rev., Admin. Law Div., Dkt. No. INC. 09-1225 (Mar. 10, 2010), most forms of non-qualified deferred compensation are taxable by Alabama, even if the recipient moves to Florida or another state and receives the payments after changing his or her state of domicile. The theory is that the individual earned the benefits (tax-free) while he or she was working in Alabama, and thus the benefits should be taxable by Alabama, regardless of where the taxpayer resides when the payments are received. But there is an often-overlooked federal law and a couple of Alabama exemption statutes we should keep in mind.

First and foremost, there is a preemptive law enacted by Congress in 1996 in response to a fight between the states of California and Nevada over which state was entitled to tax the retirement benefits earned by an individual who worked for many years in California but retired to Nevada. According to Public Law 104-95, codified at 4 U.S.C. § 114(a), “No State may impose an income tax on any retirement income of an individual who is not a resident or a domiciliary of such State (as determined under the laws of such State).” The term “retirement income” is then defined by a list of the types of plans that one would expect, i.e., qualified plans under I.R.C. section 401, simplified employee pension plans (SEPs), section 403(b) annuities (non-profit entities), IRAs, deferred compensation from a plan sponsored by state or local government or a section 501(c)(3) organization, or a couple of other, more arcane types of plans or trusts.

Good news for many of our readers: Congress amended the law in 2006 to clarify that this exemption preempts state law not only as to retired employees who change their state of domicile but to former partners as well.

Alabama law also provides an exemption for payments from “defined benefit plans” as defined by I.R.C. section 414(j) – whether or not the recipient remains in Alabama upon retirement. See Ala. Code § 40-18-19(a)(6). As the courts have noted, the definition of “defined benefit plan” does not necessarily require the plan to be tax-qualified. For this purpose only, defined benefit plans are defined more broadly to include any pension or annuity plan in which the contributions are based on a computation of what contributions are needed to provide definitely determinable benefits to plan participants. That is, contributions are dependent on promised benefits. Contributions to the plan are actuarially calculated to provide the promised benefits.

Ala. Admin. Code r. 810-3-19-.04(2). The relevant Department of Revenue regulation offers a couple of examples, including benefits received from excess benefit plans and from supplemental executive retirement income plans (SERP’s), but only if those benefits are taxable for federal income tax purposes. While that may seem counter-intuitive, that’s what the statute requires.

Additionally, while Rule 810-3-19-.04 clearly states that income from “defined contribution plans” (e.g., 401K plans) is taxable, Rep. Lynn Greer (R – Rogersville) intends to introduce legislation in February to exempt those payments as well. According to Greer, the exemption would be phased in over a five-year period. But we may also see a legislative effort to level the playing field by exempting pay-outs from both defined contribution and defined benefit plans, but only above a certain dollar threshold, e.g., $50,000 annually.

Another, more narrow exemption deals with severance pay to former employees resulting from their employer’s downsizing. See Ala. Code § 40-18-19.1. The Department has fleshed out this exemption in Rule 810-3-19.1-.01, which says that the severance payment must result from an “administrative downsizing,” i.e., a reduction in the employer’s workforce or the discontinuance or relocation of the operation of the employer in accordance with a “business plan” submitted to and approved by the Department. In addition, the employee must be “displaced from employment,” which means there has been a termination of the employer/employee relationship due to the employee’s job being “abolished or relocated.” The exemption is limited to the first $25,000 of severance pay received in any one year for the displaced worker. Examples include certain union benefits, payments from a VEBA, payments to laid-off employees from a company-financed supplemental unemployment benefit plan also known as a “guaranteed annual wage plan,” and incentives or inducements for early retirement.

In short, the general rule that payments from a retirement plan are taxable by Alabama, even if the retiree-recipient moves out of state, has some relatively broad exceptions. We hope you will make a few copies of this column and deposit them in the files of individual clients who are close to retirement and who participate in one or more qualified or non-qualified deferred comp plans.

Republished with permission from the Alabama Society of Certified Public Accountants Connections, which first appeared in January 2016.