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March 2, 2011 - State Tax Treatment of Pension and Deferred Compensation Payments

Many individual taxpayers spend their working lives in one state and retire to another state. For example, someone who worked in New York City might retire to Florida because it generally has better weather than New York and because Florida does not have a personal income tax. The question arises as to which state is entitled to tax pension income or other deferred compensation income, i.e., the state in which such income was earned or the state of residence when the income is received.  Clearly, in this example, New York State would prefer source taxation in order to tax the pension or deferred compensation earned therein. Until the enactment of recent legislation, New York tax law did, in fact, impose income tax on pension and deferred compensation earned therein, notwithstanding the state of residency of the recipient.

In response to the source tax levied by a number of states, including New York and California, a federal law, Public Law ("P.L.") 104-95, as amended by P.L. 109-264 (collectively, the "Public Law"), was enacted to prevent the taxation of pension income of former residents of a given state, e.g., New York, where the pension income was earned, and to cause taxation, if any, in the resident state where and as it is received. 

The Public Law covers payments from most tax-favored types of pension or retirement plans, including qualified retirement plans, simplified employee pensions, section 403(b) plans, IRAs, and annuity plans, among others.

In contrast to the types of pension or retirement plans described above, employers may sponsor deferred compensation plans which do not derive the benefits of a tax-favored plan.  These plans, referred to as nonqualified deferred compensation ("NQDC") plans, are popular primarily because the employer may select the participants, even if such selection discriminates in favor of highly compensated employees.

For example, payments received from a NQDC plan known as an excess benefit plan are covered by the Public Law and are therefore taxed in the recipient's state of residence. An excess benefit plan is a NQDC plan that provides benefits that would have been provided in a qualified retirement plan, but which are reduced or eliminated from the qualified retirement plan as a result of certain limitations on contributions, benefits, and compensation found in the Internal Revenue Code ("IRC"). Excess benefit plans restore the benefits which are limited by the IRC, albeit in a NQDC.

Payments from other NQDC plans are subject to source taxation unless certain additional requirements are satisfied. First, the deferred compensation must be subject to the Social Security tax timing rules found in IRC section ("§") 3121(v)(2). Under this statute, NQDC becomes subject to Social Security taxes at the later of the time the services are performed or when the NQDC is fully vested.  The Public Law does not cover any payments from equity-based compensation (e.g., stock options, restricted stock, etc.) inasmuch as these are not subject to IRC §3121(v)(2).

In addition, in order for distributions from NQDC plans subject to IRC §3121(v)(2) to be protected by the Public Law, the distributions must be:

1. Substantially equal periodic payments made at least annually for the recipient's life or life expectancy (or the joint lives or joint life expectancy of the recipient and the recipient's designated beneficiary), or;
2. For a period of at least 10 years.