Californians Missing Out on Tax Incentives

Millions of Californians won’t be able to take full advantage of new federal tax incentives to save for retirement and their children’s education unless state lawmakers change the state’s tax code.

Several state legislators plan this week to propose bills to resolve the issue. But the legislation would cost millions in tax revenue and would come as California’s budget is already under strain, making passage less than a sure thing.

Californians who want to take advantage of higher contribution limits to 401(k) plans, individual retirement accounts, education IRAs and other tax-advantaged savings vehicles are hamstrung, despite last year’s federal law allowing them to do so.

Already many state employees have been notified that they can’t boost contributions to their tax-deferred retirement plans.

“It doesn’t seem right that the law was passed for all Americans but if you live in California, you can’t do it,” said Rosemary Hart, who works for the Sacramento Municipal Utility District.

At the heart of the matter is last year’s wide-ranging new federal tax law, which slashed federal income tax rates and mandated that most taxpayers receive a refund check from the U.S. Treasury.

The law also boosted allowable contributions to IRAs to $3,000 this year from $2,000 last year. It raised limits for contributions to 401(k), 403(b) and 457 retirement plans, and gave individuals who are older than 50 the ability to contribute even more to “catch up” on retirement savings. In addition, the law quadrupled the amount parents could save for their children’s education through education IRAs.

Karen Hochwald, an Orange County homemaker, was warned by her financial planner refrain from increasing her Roth IRA contribution to the new federal limit. “This issue affects virtually every working person in the state,” Hochwald said. “Everybody has something--either an IRA, a Roth IRA or a 403(b). But [the state] could penalize you for putting too much in savings.”

California is among more than a dozen states that have tax rules that don’t mesh with the new federal tax law. Workers in these states are in a bind. They can’t enjoy the boosted retirement and education savings limits without running afoul of state law and owing more state--and in some cases federal--income taxes.

Worse yet, the situation in so-called nonconforming states might affect residents of states in which the tax laws mesh, said David Wray, president of the Profit Sharing/401(k) Council of America.

“Because some multinational companies want uniformity in their record keeping, they will hold off making changes in their entire plan until the California situation is resolved,” Wray said.

“From a company point of view, the purpose of these plans is to build a bond with employees. If you have a situation where an employee moves, you have a very complicated communication with the employee, who is not going to understand why [he or she] got treated one way in Nevada and another in California.”

Savers have all year to contribute to most types of retirement plans, and they can postpone making 2002 contributions to IRAs until April 2003. If the state passes a conformity bill this year and makes it retroactive--as several legislators have suggested should be the case--the state’s residents will be able to enjoy the full benefit of boosted savings limits. However, many workers who want to change their contribution levels now are being thwarted by employers who consider the prospects for conformity too tenuous.

There is some debate about exactly what might happen if an individual contributed more to a retirement plan than state law allowed.

Some experts think the additional amount would simply be taxable on state returns. In other words, with federal law allowing $3,000 in tax-deductible IRA contributions but state law allowing just $2,000, Californians who contributed the maximum would pay state tax on the $1,000 difference.

However, others believe that contributing even $500 too much to a tax-qualified retirement plan, such as a 401(k), would cause the entire plan to be disqualified. The result: Participants would face state taxes not just on the $500 overage but on the entire accumulated balance in the account. In some cases, it might make retirement savings taxable even on federal returns.

“If we don’t conform and individuals want to save more than California law allows, they will be double-taxed--at best,” said Assemblyman John Campbell (R-Irvine), a certified public accountant who plans to introduce a bill Monday that would make California law conform with the new federal law.

“At worst, they could face a 1,000% tax rate,” Campbell said.

Even in the best of circumstances--if the additional contributions were simply taxable on state returns--it could cause lasting headaches, said John Scott, director of retirement policy at the American Benefits Council in Washington.

The amount that was taxed by the state when it was contributed would be tax-free when withdrawn during retirement. That would require taxpayers to maintain careful records over the years, or decades, if they didn’t want to overpay their state tax.

If an individual retired to another state, the situation could become even more complicated.

“It gets pretty hairy and difficult for people and their advisors to work through,” Scott said. “But for somebody who wants to take advantage of the increased limits in federal law, it’s pretty clear that they would be penalized.”

Bringing state tax codes into conformity with federal tax-law changes usually is a simple matter, especially when popular programs such as IRAs are at stake. But accomplishing it this year is less certain, experts said. The recession has crimped tax revenue at all levels of government, and states will take a close look at any proposal that will cost them money.

California would lose $44 million in 2002 if the state fully conformed to the federal law, according to an analysis by the Franchise Tax Board. The losses would be greater in future years.

By law, the state’s $103-billion budget, now estimated to be $12.4 billion in the red, must balance, said Sandy Harrison, assistant director of the California Department of Finance. If the Legislature cuts revenue by complying with the new tax law, it will need to find other sources of revenue to make up for the loss, Harrison said.

“It is a very difficult year to do conformity,” said Assemblywoman Ellen M. Corbett, (D-San Leandro) chairwoman of the Assembly Revenue and Taxation Committee. “It’s never easy, because it always requires expenditure.

“This year, being a tough budget year, the bills will have to be crafted carefully to get a bill accepted by a majority of people.”

Wray, of the 401(k) Council, said, “In the past, you could count on getting all of the appropriate state concurrence ... and everyone could just go forward. Now you cannot make that presumption. If states conform, they lose revenue. And this happens right in the middle of an economic downturn, where states are running deficits to begin with.”

Many experts are worried that state governments will either drag their feet or conform with only a portion of the federal law as a way of saving money.

That is, in fact, what some California legislators are considering.

Corbett, for example, will introduce a bill this week to make state law conform with federal retirement plan rules. But the bill would not allow increased contributions to education IRAs. California taxpayers are restricted to contributing no more than $500 to these accounts, while federal law allows contributions of as much as $2,000.

Meanwhile, state Sen. Jack Scott (D-Pasadena) said he also will introduce a bill Monday that would make California law conform with both the education and retirement plan provisions.

California’s legislative tax committees plan to hold meetings this month to discuss various options and identify possible problems that might result if the state doesn’t conform with all provisions in the federal law. However, any effort at conformity hinges on finding ways to save money and pay for the changes, legislators say.

The suggestion makes savers, such as Hochwald, burning mad.

“What is happening here is California is trying to balance a budget on the back of working men and women,” Hochwald said.

“Our goal is to be secure when we retire and not dependent on the government. But California is not going along with that.”

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Out of Order

Here are some of the new federal tax rules for 2002 that don’t conform with California law.

* Annual contribution limits for individual retirement accounts--both Roth and traditional--are raised to $3,000 from $2,000.

* Contribution limits for 401(k) and 403(b) plans rise to $11,000 from $10,500.

* Maximum Simple account contributions rise to $7,000 from $6,000.

* Maximum 457 plan deferrals go to $11,000 a year from $8,500.

* Individuals older than 50 can make “catch-up” contributions to their retirement plans.

* Pension accounts are easier to move from job to job.

* Maximum contributions to education IRAs rise to $2,000 from $500.

Source: Franchise Tax Board