prepared by David Baer
Public Policy Institute
American Association of Retired Persons
(Presented here with the permission of the AARP)
The tax treatment of pension and Social Security income is a critical concern for older Americans because these are two of their primary sources of income. In 1994, for persons age 65 and over, 42.1 percent of all income came from Social Security benefits, while another 18.7 percent came from pension income and annuities.1
Since 1984, a portion of Social Security and Railroad Retirement benefits has been taxable by the federal government for high-income beneficiaries. Until 1993, taxation of Social Security applied to beneficiaries if their "provisional income" exceeded $25,000 for single persons or $32,000 for married couples. Provisional income was defined as the sum of (1) federal adjusted gross income (AGI), (2) tax-free interest income, and (3) one-half of Social Security benefits. If combined income exceeded these amounts, the amount of benefits that was taxable was the lesser of:
(a) one-half of the excess of combined income over the threshold amount, or
(b) one-half of the Social Security benefit.
Of the 42.2 million beneficiaries receiving Social Security
payments at the end of December 19932,
about 22 percent (9.3 million), paid income taxes on their Social
Omnibus Budget Reconciliation Act (OBRA) of 1993
Effective in tax year 1994, some Social Security beneficiaries pay
even higher federal income taxes on their Social Security benefits
due to a provision of the Omnibus Budget Reconciliation Act of 1993
(OBRA 93). OBRA 93 increased the percentage of benefits that may be
taxed from 50 percent to 85 percent for those whose provisional
incomes are $34,000 or more (single filers) and $44,000 or more
(married, filing jointly).4
There is no change in taxable Social Security due to OBRA 93 if provisional income is between $25,000 and $34,000 (single filers) or between $32,000 and $44,000 (married, filing jointly); at these income levels, up to 50 percent of the Social Security benefits may be taxed. None of these thresholds is indexed for inflation. Approximately 12.8 percent (5.4 million) of the 42.2 million beneficiaries were required to pay higher Social Security taxes due to OBRA 93 in 1994.5
Many states' income taxes are directly tied to federal taxes because their taxable base begins with federal adjusted gross income, federal taxable income, or federal taxes paid. Therefore, increases in the income tax base at the federal level, such as that resulting from the inclusion in income of Social Security benefits, will automatically result in increased state income taxes, unless state legislatures enact provisions for offsetting the federal provision.
State Taxation of Social Security Benefits
Currently, 26 of the 41 states (and the District of Columbia) that have broad-based personal income taxes exempt Social Security benefits from taxation. The 15 states that do not are Colorado, Connecticut, Iowa, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, West Virginia, and Wisconsin. These are shown in Table 1.
The impact on beneficiaries due to higher state taxes on Social Security benefits varies among the 15 states that tax Social Security benefits. Wisconsin, Iowa, and Connecticut do not pass on the higher state Social Security taxes; instead, beneficiaries pay income tax on up to 50 percent of Social Security benefits based on the older thresholds of $25,000 (single) and $32,000 (married, filing jointly). In fact, beneficiaries in Iowa paying more in federal income taxes on Social Security benefits will pay less in state taxes, since federal taxes are deductible from Iowa taxable income.
In addition, Colorado and Minnesota reduce tax liability from higher federal taxation of Social Security benefits in the following ways:
Colorado allows Social Security benefits to be included in a $20,000 elderly income exemption; and
Minnesota exempts up to $800 (for single filers or for married couples filing jointly in which only one spouse qualifies) and $1,000 (for married couples, filing jointly) in higher Social Security benefits included in federal adjusted gross income due to OBRA 93. These exemptions are reduced by 20 percent for each $1,000 of adjusted gross income above $60,000 (for single filers, or for married couples filing jointly in which only one spouse qualifies) and above $75,000 (for married couples, filing jointly where both spouses qualify). These exemptions expire after tax year 1996.
As in Iowa, beneficiaries in Montana paying more in federal income taxes on Social Security benefits will pay less in state taxes, since federal taxes can be deducted if taxpayers itemize. Some beneficiaries in Montana also get an exclusion from Social Security benefits based on differences between the federal and Montana tax bases.
How States Treated Pension Income in 1996
Supreme Court Cases
Prior to 1989, many states fully exempted state pensions from
income taxation. In March 1989, the U.S. Supreme Court's Davis v.
Michigan decision (489 U.S. 803) ruled that states must
treat federal pensioners at least as well they treat their state
pensioners. The Court expanded this decision in April 1992, ruling in
Barker v. Kansas (503 U.S. 594) that states are prohibited
from taxing the pension benefits of U.S. military retirees while
exempting the pensions of state and local government
An issue not addressed by the Davis decision was whether states affected by the Davis decision must give refunds to those federal retirees who paid taxes under laws struck down by the Davis decision. In June 1993, the U.S. Supreme Court gave its first direct ruling on this matter in Harper v. Virginia Department of Taxation (509 U.S. 86). The court did not require states to pay refunds, but ruled that states would have to "provide relief consistent with federal due process principles" if state predeprivation procedures were unavailable.
Predeprivation procedures are any methods which state governments provide taxpayers for contesting a tax before its payment. This relief could involve refunds. States with adequate predeprivation procedures may not have to take remedial action. State courts will first decide whether predeprivation procedures exist and whether these procedures provided federal retirees with opportunities to contest the tax. All affected states have settled with or are paying affected federal retirees.
State Taxation of Pensions
Table 1 summarizes the income tax treatment of pension income for tax year 1996 for the 41 states and the District of Columbia that have a broad-based income tax. The chart describes pension exemptions for single filers only.
The income restrictions column reveals only whether or not pensioners' incomes preclude them from receiving any exemption benefit; it does not indicate whether exemption amounts are reduced based on income levels. The endnotes to Table 1 give more detail about other retirement income exclusions (e.g., exclusions based on all retirement income, not just pension income), other filing statuses, age and income restrictions (both for pension income and other retirement income), and elderly tax credits.
Most states that have an income tax exempt at least part of pension income from taxable income. Different types of pension income (private, military, federal civil service, and state or local) are often treated differently for tax purposes.
Only four states -- Hawaii, Illinois, Mississippi, and Pennsylvania -- exempt all pensions, both private and public, from taxation. Hawaii exempts noncontributory private pension income. However, Hawaii taxes earnings and exempts employee contributions to contributory private pension plans.
Six states fully exempt public pensions (federal, military, state, and local pensions) but do not fully exempt private pensions. These states are Alabama, Kansas, Kentucky, Louisiana, Michigan, and New York. Alabama fully exempts public pensions, but exempts only those private pensions that are defined benefit plans.
Wisconsin fully exempts public pensions only for taxpayers who
retired prior to 1964 or who became members of the retirement system
before 1964. Massachusetts exempts federal, state, and local pensions
but not military pensions.7
Sixteen states and the District of Columbia offer pension exemptions that vary by type, with public pensions generally treated more favorably than private.8
Some states offer at least partial exemptions for some types of pensions. Seven states specifically offer the same partial exemptions for all pensions. These are Arkansas, Colorado, Delaware, Montana, New Jersey, South Carolina, and Utah. Georgia, Iowa, Minnesota, New Mexico, and Virginia do not provide exemptions just for pension income but for income from any source, including pension income. Utah exempts $4,800 in pension income and taxable Social Security benefits (for those under the age of 65); Utah exempts up to $7,500 on all income sources for those age 65 and over.
The following eight states allow no exemptions for pension and/or other retirement income that is counted in federal adjusted gross income: California, Connecticut, Maine, Nebraska, Ohio, Oregon, Rhode Island, and Vermont. However, except for Connecticut, the other states offer some type of tax credit specifically for taxpayers age 65 and older.
Oregon, however, offers a retirement income tax credit for taxpayers age 60 and over whose household income is less than $45,000 (married, filing jointly) or $22,500 (other filing statuses) as well as an elderly tax credit equal to 40 percent of the federal elderly tax credit. Oregon residents can apply for only one of these credits.
Of the 32 states and the District of Columbia offering exemptions for pension income and/or for any other retirement income source, 14 states and the District of Columbia require pensioners to be a certain minimum age (varying from 55 to 65) to receive a tax exemption.9
Exemption amounts for pension and/or other retirement income for seven of the states (Delaware, Maryland, Minnesota, Missouri, Montana, New Mexico, and Utah) are based on taxpayer income. Pension exemptions and exemptions from any income source are reduced by Social Security benefits and/or Railroad Retirement benefits in Idaho, Indiana (only for federal civil service pensioners), Maryland, Minnesota, and North Dakota.
State pensions are usually not tax-exempt if earned in another state. The policies are described in the endnotes to Table 1.
Starting in tax year 1996, all states are prohibited from taxing distributions from nonresident pension and other retirement income plans because of a federal law (Public Law No. 104-95) passed in December 1995. Although most forms of retirement income plans are now exempt because of this law, examples of retirement income that are still taxable include nonqualified plans that are periodically paid out in less than ten years and various forms of compensation, such as stock options, severance pay lump-sums, and incentive bonuses that are typically paid to highly compensated employees.
The revenue loss to New York from the new federal law is estimated
at $10 million per year.10
California estimated its revenue loss at $25 million per
year.11 Although states like New
York and California will lose tax revenues from this law, some states
will benefit. States that have offered their residents credit for
income taxes paid to states that previously taxed the retirement
income of former state residents will realize increased tax
Vermont, Massachusetts, Minnesota, and Wisconsin still tax nonqualified plans and various forms of compensation of former state residents still allowed under the new federal law. Other states might also decide to tax former residents if it is cost effective for them to do this.
Former residents who earn taxable nonqualified pension income must file non-resident income tax forms. In most states where the state of residence also has an income tax, that tax can be credited against the income tax owed to the state of former residence.
The tax treatment of lump sum distributions varies considerably by
state, but most offer some kind of averaging of income for tax
How States Treated IRAs in 1996
Three states (Pennsylvania, New Jersey, and Massachusetts) do not allow IRA contributions to be deducted from taxable income. Unlike New Jersey and Massachusetts, however, Pennsylvania does not tax IRA earnings of taxpayers age 59 1/2 years and older for whom such earnings are treated like pension income which is tax exempt.
Delaware allows deductions for contributions for joint and single filers; however, if a couple files their federal return jointly and their Delaware return separately, an adjustment may be necessary. In particular, if the federal adjusted gross income is less than $10,000, the allowable deduction is to be prorated, while no deduction is allowed when the federal adjusted gross income exceeds $10,000.
For 1981 through 1986, Georgia and California did not conform to federal eligibility and deduction rules but followed federal rules that had existed from 1975-81. This resulted in many taxpayers receiving a $2,000 federal deduction while receiving only a $1,500 state deduction. In addition, taxpayers who were covered by an employer-sponsored qualified retirement plan could not deduct their contributions from their state returns but could deduct them from their federal returns.
1 Social Security Administration, Office of Research and Statistics, Income of the Population 55 or Older, 1994, (Washington, DC: U.S. Government Printing Office, January 1996), p. 111.
2 Board of Trustees, Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, 1994 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, (Washington, DC: U.S. Government Printing Office, 1994), p. 2.
3U.S. House of Representatives, Committee on Ways and Means, 1993 Green Book. (Washington, DC: U.S. Government Printing Office, 1993), p. 32.
4Provisional income includes adjusted gross income plus tax-exempt interest plus certain foreign-source income and one-half of the taxpayer's Social Security or Railroad Retirement Tier 1 benefit. (U.S. House Committee on the Budget, Omnibus Budget Reconciliation Act of 1993, 103rd Cong., 1st sess., 1993, Conference Report 103-213, p. 594.)
5Estimate based on the AARP- Barents Group Individual Income Tax Model.
6Courts held that the Barker v. Kansas (503 U.S. 594) case did not apply to Massachusetts, since the state's system of taxing pensions, i.e., exempting contributory pensions and taxing noncontributory pensions, is different from Kansas's tax system.
7 The 1992 U.S. Supreme Court case Barker v. Kansas (503 U.S. 594) ruled that the state are prohibited from taxing the pension benefits of U.S. military retirees while exempting the pensions of state and local government retirees. Courts held that this case did not apply to Massachusetts, since the state's system of taxing pensions, i.e., exempting contributory pensions and taxing noncontributory pensions, is different from Kansas's tax system.
8 These states are Alabama, Arizona, Idaho, Indiana, Kansas, Kentucky, Louisiana, Maryland, Massachusetts, Michigan, Missouri, New York, North Carolina, North Dakota, Oklahoma, and West Virginia.
9 These states are Colorado, Georgia, Idaho, Indiana, Iowa, Louisiana, Maryland, Minnesota, New Jersey, New Mexico, New York, North Dakota, Pennsylvania, and Virginia.
10 New York State Department of Taxation and Finance.
11 California Franchise Tax Board.