Segal’s Compliance Alert December 27, 2001 #2

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December 27, 2001
Updated: February 28, 2003

State Income Tax Laws May Complicate New Defined Contribution Plan Allocations Authorized by EGTRRA

If states do not conform their income tax laws to the federal Internal Revenue Code (IRC), the increased retirement savings that individuals can make under the Economic Growth and Tax Relief Reconciliation Act (EGTRRA)* may be taxable under state law. In addition, employers would have state income tax withholding and reporting responsibilities.

Implications

If a state’s income tax law says, for example, “taxable income for state purposes includes items treated as taxable income under the Internal Revenue Code as amended through 1998,” it seems that the state tax would apply to plan-related payments that were included in federal taxable income before the 2001 enactment of EGTRRA. The clearest examples of this are:

50+ Catch-Up Contributions EGTRRA Authorizes employees age 50 and above to make extra contributions (“50+ catch-up contributions”) to Section 401(k), §403(b) and governmental §457 plans. (The regular §457 catch-up contributions and the special §403 catch-up contributions are not affected.)
“Exotic” Rollovers In addition to authorizing rollovers among §403(b), governmental §457 and private-sector plans, EGTRRA permits rollovers of after-tax contributions (“exotic rollovers”), which, previously, were not allowed.

Once these contributions are taxed under state law, the state would not tax them again when they are later paid out. An exotic rollover would be taxable when the funds are distributed from the first plan, so they would not be taxed under state law when ultimately distributed from the plan to which it was rolled over. In both cases, this is the opposite of the federal tax treatment. Thus the recordkeepers and payroll services would have to be able to account for these funds separately for state and federal tax purposes, both when they come in and when they go out.

Another area of possible inconsistency between state and federal law is the maximum annual amount that an individual can elect to save on a pre-tax basis. EGTRRA provides that, in 2002, the overall annual limit on pre-tax contributions is scheduled to rise to $11,000. That is, where it would have been as a result of indexing under the old law, so it should not create state-tax problems. There may be issues after 2002, however, as the limit goes past what would have been allowed under the old law and gradually rises to $15,000 under the terms of EGTRRA.**

Public sector plans are created by the same state legislatures that enact the states’ tax laws. Ultimately it will be those legislatures that decide whether to allow the plans to provide benefits that are taxable under state law.

Nonconforming States

As of February 27, 2003, when Governor Huckabee signed legislation to make Arkansas law conform to EGTRRA, the only two nonconforming states are:

New Jersey — In New Jersey, the catch-up contributions authorized by EGTRRA will be tax-favored only for §401(k) plans, not for §403(b) plans or §457 plans.
Pennsylvania — Pennsylvania does not recognize any employee deferrals to retirement plans.

Options for Plan Sponsors

In consultation with their attorneys, plan sponsors will need to make a practical business judgment about how far to pursue the details of state tax laws, weighing the possible consequences of the alternatives. Here are some approaches that might merit consideration.

Separate Accounting Plan sponsors covering employees who live in nonconforming states that want to take full advantage of the EGTRRA opportunities may be able to arrange separate state and federal tax reporting and recordkeeping systems for the new types and levels of deferrals and rollovers.
Selective Application of New Features A plan covering people living in different states might be able to restrict the problematic new EGTRRA features to people living in states with tax laws that conform to the federal law. This would complicate administration and recordkeeping, and would be acceptable only if it is nondiscriminatory. Also, if an employer offers the opportunity to make catch-up contributions to any of its employees, it must offer that chance to all of its employees age 50 or older who participate in salary reduction plans, so selective application is not an option there.
Wait for Clarification Most plan sponsors faced with this dilemma will probably decide to wait before adopting the new features that are most likely to cause state-law problems until the tax issues are clarified and, ideally, the states’ tax laws are amended to fit the EGTRRA design. This means that, at least at first, they will not accept catch-up contributions or exotic rollovers.

* To see the text of EGTRRA, click here.

** In setting their tax-enforcement priorities, states are most likely to purse the easiest targets: individuals receiving money but avoiding tax on it by putting it into the employer's plan. While theoretically there may be issues about a plan's continuing to qualify for its own tax-exemption under state law, or about the deductibility of contributions, the relevant state-law considerations are likely to be different and it seems less likely that state tax authorities will concern themselves with those more intricate aspects of plan operations.

Compliance Alert, The Segal Company’s periodic electronic newsletter summarizing important developments affecting benefit plan compliance, is for informational purposes only. It is not intended to provide authoritative guidance. On all issues involving the interpretation or application of laws and regulations, plan sponsors should rely on their attorneys for legal advice.