For many, working in one state and living in another is a common situation.  For example, a 2013 report cited by the New York Times estimates that nearly 400,000 people commute from New Jersey to New York each day.  For those commuters, filing an income tax return in both states each year is the norm.  The typical process is to withhold and pay tax in the state where you work while you also file in your resident state and claim a credit for taxes paid to the non-resident state.  For those who cross state lines to work, there is also no avoidance of paying state income tax simply by working in a tax-free state.  If you live in a state that has an income tax and work in a non-tax state, you still must pay tax to your home state on all of your income regardless of where you earned it.

Is this also true for a retiree who has moved to a low- or no-income tax state but has remaining compensation earned while working in a higher tax state?  A recent case before the Connecticut Supreme Court weighed in one this issue as it pertained to non-qualified stock options granted while the plaintiff-executive worked in CT.  The executive subsequently retired to Nevada where there is no state income tax and retained the unexercised options which were vested to him.  As a Nevada resident he exercised approx. $53MM of option value and then sought a refund for approx. $3MM in CT state income taxes that were withheld at the time of exercise.  On December 28, 2016 the CT Supreme Court ruled that Connecticut can rightfully tax this income and denied the executive his requested refund. This result is not surprising as stock options are viewed as items of non-qualified deferred compensation and generally will be taxable in the state where earned and granted (or became vested to the employee).

Would such an outcome be true for other types of retirement benefits such as pension and deferred compensation plans?  To understand how this aspect of law works for retirees, it is useful to understand how the law evolved in this area.  In years past, several states enacted “source tax” laws to tax compensation and retirement benefits earned in that state, regardless of where a taxpayer resided when such benefits were ultimately paid. For example, if you earned a $50,000 annual pension benefit while working in New York and retired to Florida (where there is no state income tax), New York could attempt to tax those benefits even though you were no longer a New York resident.

However, this changed in 1996 when a federal law was enacted (P.L. 104-95) prohibiting states from taxing certain retirement benefits paid to nonresidents.  As a result, if your retirement benefits are covered by this law, only the state in which you reside (or are domiciled) can tax those benefits.   This law applies to all “qualified retirement plans” such as 401(k), 403(b), 457 plans; Profit Sharing Plans; Defined Benefit Plans; IRAs; and SEP IRAs.   For “non-qualified retirement plans” (such as deferred compensation plans, SERP, Stock option, stock appreciation rights and restricted stock plans), the payments are covered by the law only if the plan benefits are payable over the employee’s lifetime or for a period of at least 10 years.  Therefore, a retiree with a deferred compensation plan wanting to retire to a non-tax state may be better off (if allowed by the plan) electing to receive their deferred compensation plan payout over a period of at least 10 years in which case the benefits will be taxed to the state of residence as opposed to the state where the compensation that funded the plan was earned.

 

 

Wealthspire Advisors is the common brand and trade name used by Sontag Advisory LLC and Wealthspire Advisors, LP, separate registered investment advisers and subsidiary companies of NFP Corp.
This information should not be construed as a recommendation, offer to sell, or solicitation of an offer to buy a particular security or investment strategy. The commentary provided is for informational purposes only and should not be relied upon for accounting, legal, or tax advice. While the information is deemed reliable, Wealthspire Advisors, LP cannot guarantee its accuracy, completeness, or suitability for any purpose, and makes no warranties with regard to the results to be obtained from its use. © 2019 Wealthspire Advisors

Craig Fasano, J.D.

Craig is a managing director in our New York headquarters.