Thursday, August 18, 2011

Michigan's "new" state tax on retirement distributions

The article of faith among Republicans appears to be that new taxes of any kind are unacceptable, regardless of why or how. But that is not the case with Michigan's new Republican governor, Rick Snyder. Among the reforms that were put into place this year, the most prominent of which was the abolition of the Michigan Business Tax and its replacement by a state tax on corporate profits, Michigan modified the tax treatment of distributions from pensions and retirement programs.

Michigan has not adopted a new tax. Pension distributions were subject to tax previously, but there was a fairly high exemption. What Michigan has done is significantly lower the exemption.

One justification that has been made for this step is that the exemption of distributions was inconsistent with the overall structure of retirement plans. IRAs and 401(k) plans are built up with untaxed money. The contributions are not taxed at the time they are made. Rather, the funds grow (if the participant is fortunate) and then are taxed only when they are distributed. That is what happens at the Federal level. All such distributions are taxed as ordinary income. At the state level, where other income is taxed at a flat 4.35% after the application of the personal exemption, the distributions from those accounts were not taxed under previous law until they exceeded $45,120 per person, or $90,240 per couple.

The newly-adopted plan has several exceptions and limitations:

  • It does not apply at all to those who will be 67 or older by the end of 2011. For them, the current exemptions will remain in effect.
  • The exemption is reduced to $20,000 per person, $40,000 per couple. For those earning more than $75,000/$150,000, that exemption is phased out.
  • For those who are 60 to 66 by the end of 2011, those figures apply beginning in 2012.
  • For all others, that exemption will apply only after age 67. Any distributions between ages 60 and 67 will not have any exemption other than the small state personal exemption. (The thinking apparently is that most people will not be living on retirement income until age 67.)
  • After age 67, the taxpayer may elect to have the tax apply to his social security benefits instead of pension distributions.
  • Significantly, social security benefits (unless the election is made) and military pensions will remain entirely exempt.

There have been legislative proposals to add police and firefighter pensions to the exempt list.

More: The state's information site.

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