Liberalized Contribution Rules in EGTRRA Could Cause State Income Taxes

By Dave Baker

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State tax laws are causing concerns for some retirement plan practitioners. In states that impose an income tax on individuals, retirement plan sponsors may need to determine whether the state's income tax code will take into account the more liberal EGTRRA contribution limits allowed in 2002 under the federal income tax code.

Although some states have tax statutes that automatically track the version of the federal income tax code as in effect for any particular year, other state tax statutes are based on the federal income tax code as in effect on a certain date, such that later changes to the federal code become effective only when the state adopts legislation expressly incorporating the change.

A report recently prepared by Fidelity Investments lists the following states as having such a "nonconforming" scheme: Alabama, Arizona, Arkansas, California, District of Columbia, Georgia, Hawaii, Idaho, Indiana, Iowa, Kentucky, Maine, Massachusetts, Minnesota, New Jersey, North Carolina, Oregon, South Carolina, West Virginia and Wisconsin.

Fidelity's report notes the following potentially significant state income tax effects, if a state does not choose to incorporate the higher EGTRRA contribution limits:

Inclusion in state taxable income of the amounts contributed to retirement plans and IRAs that are non-deductible for state tax purposes; Inclusion in state taxable income of amounts rolled over to types of retirement accounts that were not eligible to receive tax-free rollovers under the federal tax code prior to EGTRRA, such as a rollover from a section 457 plan to a section 401 retirement plan that has been amended to accept such rollovers; Increased recordkeeping burdens for individuals to keep records of the non-deductible (for state income tax purposes) portion of their contributions to retirement plans and IRAs; Recordkeeping and reporting burdens for employers who may be required by the state to track and report non-deductible (for state income tax purposes) amounts contributed to retirement plans; Recordkeeping and reporting burdens for IRA or retirement plan service-providers who may be requested to separately account for the non-deductible (for state income tax purposes) portion of contributions; and Potential disqualification of retirement plans and IRAs for state income tax purposes, and corresponding loss of tax deferral for state income tax purposes on the assets held in the plans and IRAs. For example, a retirement plan that takes into account compensation up to $200,000 in 2002 for purposes of its benefit formula technically might cause the plan to be disqualified for state income tax purposes, because the use of that higher limit would violate the pre-EGTRRA compensation limit that was in effect on the date the state incorporated the then-existing federal income tax code (in Massachusetts and California, for example, personal income tax laws generally are based on the version of the federal tax code that was in effect on January 1, 1998).

One possibility for relief is that nonconforming states might pass legislation adopting the EGTRRA changes retroactively. An employer having employees in such a state could operate its plan on an assumption that such a retroactive change will occur.

Other employers might wish to prepare to keep records of amounts that would be taxable under state law, for purposes of reporting and withholding (e.g., to determine an employee's tax basis in his account).

An employer concerned with the possibility of disqualification at the state level might wish to forego taking advantage of the EGTRRA rules by refraining from amending its plan to use the higher contribution limits.