Tax-free Pension Rollovers into IRAs

By Mark H. Levin

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The New York State Tax Law, section 612(c)(3)(i), provides, “[T]here shall be subtracted from federal adjusted gross income: Pensions to officers and employees of this state, its subdivisions and agencies, to the extent excludable in gross income for federal income tax purposes.” Tax Law section 612(c)(3-a) provides that the first $20,000 per year of any pensions or annuity income [which are not otherwise tax-exempt under Tax Law section 612(c)] received by individuals over the age of 59 Qs at the time of the receipt of the distribution are also exempt from income taxation.

Based on this provision, all pensions received by officers and employees of New York State, its subdivisions, and its agencies, are exempt from state income taxation. It is less clear whether the tax-exempt attribute of the governmental pension remains intact after it is rolled over, in a tax-free transaction, into an individual retirement account (IRA).

In two recent Advisory Opinions, Larry J. Green [Adv Op Comm T&F, TSB-A-03(4)I, November 19, 2003] and Richard Epstein [Adv Op Comm T&F, TSB-A-03(5)I, November 19, 2003], the New York State Department of Taxation and Finance has stated that when a tax-exempt governmental pension is rolled over in a tax-free transaction into an IRA, any distributions from the rollover IRA will be tax exempt to the extent that they are attributable to the tax-exempt amount rolled over into the IRA. Any subsequent income or growth of the initial tax-exempt amount rolled into the IRA is taxable to the extent provided in Tax Law section 612(c)(3-a). The opinions also set forth the method for calculating taxable and nontaxable portions of any distributions from the rollover IRA.

In applying the opinions, it is clear that the rollover IRA is partially tax exempt, raising the question as to how to compute the tax-exempt amounts under Tax Law sections 612(c)(3)(i) and 612(c)(3-a).

In reaching its opinions, the department looked back 23 years to an old advisory opinion, Joseph W. Martiney [Adv Op St Tax Comm, November 24, 1980, TSB-H-80-(523)I]. In Martiney, “the distributions from an IRA established by means of a tax-free rollover of amounts received in the form of a distribution from New York State or a subdivision or agency thereof, represents a nontaxable return of principal to the extent that the distribution is a return of pension funds rolled over” into the IRA. To the extent that the distribution represents interest, or any other type of income or gain earned in the account, such portion would be subject to tax.

In the opinions, the department sets forth the method for computing the nontaxable portion of any amount distributed from an IRA whose principal consists of tax-exempt monies: “in a partial distribution of an IRA established by means of a tax-free rollover, to determine the amount that represents a return of nontaxable funds, the amount of contributions rolled over … to the IRA should be divided by the total value of the IRA, including the amount of the distribution, … and the result should be multiplied by the amount distributed. This computation is used for the initial year that a distribution is made and each succeeding year until the amount of nontaxable contributions is recovered.” New York’s formula is based upon that found in IRS Notice 87-16, 1987-1 CB 446. Any distribution in excess of the nontaxable amount so computed is taxable pursuant to the provisions of Tax Law section 612(c)(3-a).

A taxpayer receiving a distribution from an IRA that has been funded through contributions of tax-exempt monies can exclude from income an amount computed using the above formula. Any taxable balance may then be added to any other pension or annuity income, if any, that qualifies under Tax Law section 612(c)(3-a) and Regulations section 112.3(c)(2). The first $20,000 will be excluded; any remainder will be subject to income taxation by New York State.


Mark H. Levin, CPA, is manager, state and local taxes, at H.J. Behrman & Company, LLP.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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