Employee Benefits Bulletin, January/February 2002
EGTRRA...Nonconforming State Law
May Alabama Employers Offer the New EGTRRA Features in Their Retirement Plans?
Last year Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA"). EGTRRA contains many provisions allowing individuals to save more in their retirement plans. The most well-known and attractive of these new provisions are the increased elective deferral limits and the catch-up contributions for eligible individuals over age 50. However, some state income tax laws create difficulties for retirement plan participants taking advantage of these new provisions. If the state in which the participant works has not updated its laws to mirror the new federal EGTRRA provisions, inconsistent tax treatment may result for the participant and his or her employer.
For example, consider Julie, a 50 year old participant who defers $12,000 of her salary into her 401(k) plan. This action is permissible under federal law. EGTRRA allows an $11,000 salary deferral (a $500 increase from 2001), as well as a $1,000 catch-up contribution deferral (not available in 2001). In addition to saving $12,000 towards retirement, Julie has decreased her federal taxable income by $12,000. If Julie works in a state where the tax laws are inconsistent with the federal EGTRRA law, however, the extra $1,500 in retirement savings allowed by EGTRRA ($500 increase plus $1,000 catch-up contribution) will be subject to state income tax. For state tax purposes, Julie has made a $1,500 after-tax contribution to the plan. She may not roll over the after-tax amount into another plan, and she will be subject only to federal income tax on that amount at distribution (since she paid the state tax in the year of contribution).
This inconsistency obviously creates administrative and recordkeeping burdens for the plan sponsor. For instance, the plan must track the tax basis created by the after-tax contribution, the plan's income tax withholding system must reflect differences in federal and state taxable amounts, and the plan should educate employees about the potential for inconsistent tax treatment of their retirement plan contributions. Additionally, an employer may lose its own state tax deduction for its contributions to the retirement plan above the old, pre-EGTRRA federal limits, and these excess employer contributions could conceivably disqualify the entire plan for state tax purposes.
Employee benefits industry groups have identified the following as states with income tax laws that are fully or partially "nonconforming" with EGTRRA: Alabama, Arizona, Arkansas, California, District of Columbia, Georgia, Hawaii, Idaho, Indiana, Iowa, Kentucky, Maine, Massachusetts, Minnesota, New Jersey, North Carolina, Oregon, Pennsylvania, South Carolina, West Virginia, and Wisconsin.
Most of the "problem" states' inconsistencies with EGTRRA arise because the state imposes state income tax liability based generally (plus or minus a few items) on federal taxable income statutes as of a certain date. For example, if a state's taxable income is based upon federal taxable income as defined in the Internal Revenue Code as of 1998, obviously, the state's law will not include the 2001 EGTRRA provisions.
Alabama does not have the "fixed date" problem. However, an inconsistency with EGTRRA has been created due to the way in which Alabama's income tax references the Internal Revenue Code. Through Alabama Code §40-18-14(3)(j), Alabama excludes from gross income "contributions made by an employer on behalf of an employee to a trust which is part of a qualified cash or deferred arrangement (as defined in 26 U.S.C. §401(k)(2) . . .) . . . and contributions made by an employer for an employee for an annuity contract, which contributions would be excludable from the gross income (for federal income tax purposes) of the employee in accordance with the provisions of 26 U.S.C. §403(b). The limitations imposed by 26 U.S.C. §402(g) [elective deferral limits] shall apply for purposes of this paragraph." By direct reference to the Internal Revenue Code sections governing 401(k) and 403(b) plans, Alabama's law is automatically updated to parallel changes to the federal law in those Internal Revenue Code sections. However, new sections of the Internal Revenue Code that did not exist before 2001 because they were created by EGTRRA (such as 26 U.S.C. §414(v), the catch-up contribution section) cause inconsistency because there is no corresponding reference already present in the Alabama Code. The reference must be added. Ann Winborne, a CPA and Administrative Support Manager in the Individual and Corporate Tax Division of the State of Alabama Department of Revenue describes the creation of inconsistency in the following way:
Alabama is tied to the federal code in most of the areas changed by EGTRRA; however, in areas that Alabama's law is not specifically tied to a federal code section, Alabama will not follow the EGTRRA provisions. One such area is the catch-up contribution provisions provided under 26 U.S.C. § 414(v). There is no tie to this section in Alabama's code. . . . Until a legislative act can be passed to amend the Alabama code to follow the federal law, only those sections in the Internal Revenue Code to which the Alabama code is specifically tied will be followed.
Mike Mason, Director of Tax Policy at the Alabama Department of Revenue, agrees with the above assessment and indicates that the Alabama Legislative Reference Service is drafting a bill to remedy the catch-up contribution inconsistency. Therefore, in summary, Alabama plan sponsors and participants should not have problems stemming from the EGTRRA increase in contribution and traditional deferral limits (or with the new EGTRRA rules allowing rollovers to different types of plans). Whether Alabamians can exclude catch-up contributions depends upon whether the Alabama legislature adopts some form of the catch-up contribution bill currently being drafted; if not, Alabamians may not exclude catch-up contributions from state tax liability, and the tracking and rollover problems experienced by "Julie" in the example above will result.
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