Ex-New Jersey Residents: Your Retirement Income May Be Insulated Against New Jersey State Income Tax
It is not uncommon for executives residing in New Jersey during their peak income-producing years to relocate to another state upon retirement. Frequently, a substantial portion of the compensation earned during those years has been invested in employer-sponsored retirement plans, either tax-qualified plans (401K, Keogh, pension plans, etc.) or nonqualified plans providing for deferred compensation. Most such plans, whether qualified or nonqualified, are drafted in such a way as to defer the imposition of income tax - both federal and state - on contributed compensation until such time as the income is withdrawn, typically after retirement (when the retired employee's effective income tax bracket may be substantially lower). Of course, income tax deferral - whether of federal or state taxes - almost always works to the taxpayer's advantage, if for no other reason than because of the ability to invest the deferred income on a "pre-tax" basis and thereby augment the economic returns on investment.
In addition to the ordinary economic benefits derived from pushing off into the future the income tax on compensation, there may be a significant state income tax benefit available to retired employees who retire in low- or no-income tax states, such as Florida or Nevada. The basis for this additional benefit is a little-known federal statute enacted in 1996, sometimes referred to as the State Taxation of Pension Income Act of 1995 (P.L. 104-95, 1/10/96) (the "Act").
The Act essentially prohibits, as a matter of federal law, any state from imposing personal income tax on certain designated types of retirement income, if such income is paid to persons who are not considered "resident" in such state under that state's internal laws. Significantly, this prohibition applies even if the retirement income in question was actually earned during a time when the employee was a resident of the state, or was otherwise "sourced" to that state by virtue of the employee's physical presence there.
The principal focus of the Act is retirement income under so-called "qualified" plans, which include the sorts of retirement plans with which most employees are familiar, such as 401K plans (or, for employees of tax exempt organizations, 403(b) plans), and qualified pension (either "defined benefit" or "defined contribution") plans, all of which generally permit the deferral of taxation on limited amounts of earned compensation income until after the employee's retirement. In addition, however, the Act protects from state taxation withdrawals from a limited class of nonqualified deferred compensation plans ("NDCPs"), thereby potentially allowing the complete avoidance of personal state income tax liability that would otherwise be imposed by the state in which such deferred compensation was actually earned.
This additional class of retirement income to which the Act applies essentially comes in two flavors: (1) NDCPs requiring distributions to be paid out in a series of substantially equal (and at least annual) payments, that continue for either the life of the participant or not less than ten years; and (2) certain NDCPs maintained "solely" for the purpose of providing retirement benefits in excess of the income limitations and nondiscrimination rules established in various sections of the Internal Revenue Code (these are sometimes known as "supplemental executive retirement plans" or "excess benefit plans" or "wraparound" plans).
While there are still some definitional issues surrounding the question of how to determine whether a plan has been maintained "solely" for the purpose of supplementing participation limitations contained in the Code, the Act is a major boon for retirees relocating to low- or no-tax jurisdictions after retirement, as it provides the means by which a potentially significant tax burden may be altogether avoided. Executives seeking to avail themselves of this boon should consult with tax counsel to determine whether they (and the retirement plans in which they are invested) may qualify for this valuable post-retirement tax benefit.