Tax Impasse Could Harm Retirees

Efforts in Sacramento that would allow Californians to take full advantage of new federal retirement savings incentives may be too late to help some of the state’s taxpayers.

Retiree Beth O’Brien, for one, is facing a $3,000 tax bill on a distribution from her public employee retirement account if lawmakers don’t change the state’s Tax Code this spring. And the Laguna Woods resident isn’t happy about it.

“You can’t ‘retroact’ that,” said the former management analyst for the city of Los Angeles. “Many retirees who receive quarterly or annual [retirement] distributions probably do not yet realize what the state’s failure to act is about to cost them.”

Lawmakers are working feverishly to correct the problem, but they acknowledge that they’re getting a late start.

“We knew we needed to move quickly, but I don’t think we [fully appreciated] the urgency,” said Assemblyman John Campbell (R-Irvine), who introduced one of three bills aimed at resolving the matter.

The plight of O’Brien and thousands of current and former public employees, including firefighters, police officers and other state and local employees, is part of the fallout from the Legislature’s failure to make the state’s tax laws conform with the tax bill Congress passed in May.

That law, which cut federal income tax rates and mandated refund checks for millions of Americans, also increased the amount workers can contribute to tax-advantaged savings plans such as individual retirement accounts and 401(k)s.

It also improved public employee retirement plans such as 457 and 403(b) plans, which are used by 1.8 million California public employees and schoolteachers, by making them more flexible.

But there’s a catch. The state must adjust its tax laws, or residents who try to use some of the new tax-saving provisions will owe additional state income tax on their retirement savings.

It was thought lawmakers had plenty of time to change the state’s tax laws. After all, the deadline for many 2002 retirement plan contributions isn’t until April 2003.

But as O’Brien’s predicament shows, the effect on many Californians is more immediate.

In two months, O’Brien will be getting her annual mandatory 457 retirement plan distribution check for $10,000. The 2001 federal tax law allows her to roll the distribution into another retirement plan, thereby avoiding an immediate income tax bill. But because state law hasn’t yet been changed to allow these rollovers, she’s stuck.

Unless the state passes conformity legislation within 60 days of that distribution, O’Brien will owe more than $3,000 in state and federal income taxes and forever lose the chance to put that money in a tax-deferred retirement account, she said.

Tom Lawrence, a 57-year-old computer coordinator for the city of Santa Ana, has a different issue. He’s about to retire and will need to make an irrevocable decision about his pension. The decision he wants to make--to buy state retirement credits for the years he spent in the military with money he has saved in his 457 plan--is possible under the new federal law, but not in California.

Unless state tax laws are changed, Lawrence faces a tough choice. He can pay for the retirement credits with after-tax money--a choice that would cost him roughly 30% in additional taxes--or he can forgo buying those credits. If he doesn’t buy the retirement credits, it will reduce Lawrence’s monthly retirement checks by $350 for the rest of his life. No amount of retroactivity will help, because state pensions don’t allow changes after retirement--even if the law changes.

Teachers who retire in California could face a similar problem if they want to use their deferred compensation accounts, called 403(b) plans, to buy pension credits as federal law allows them to do, said Jim Mosman, chief executive of the California State Teachers’ Retirement System.

“If you retire and the law is later changed, you are out in the cold with respect to being able to purchase the [retirement] benefits,” Mosman said.

*

Postponing Retirement Seen as Possible Option

The only option for people in this situation is to postpone retirement, Mosman said. Officials at the California Public Employees’ Retirement System say there’s one more option--workers can “unretire.”

Going back to work for a few months after retirement allows them to return to active service status in the public employees’ retirement plan.

Returning stops retirement payments and gives workers another chance to make retirement elections when they retire again. But this option applies only if the worker is rehired.

But postponing retirement isn’t always possible. Lawrence had sold his house and made plans to move to the East Coast before he had an inkling that California’s tax law would trip him up.

“I’m hanging by a thread,” Lawrence said. “If legislators wait around for another six months, I’m going to be out of luck.”

As Assemblyman Campbell points out, the severity of the problem took California officials by surprise. Another state official, speaking on condition of anonymity, confirmed that lawmakers were largely unaware of the effect of moving too slowly.

“We thought retroactivity would cover it,” the official said. “Clearly, there are all sorts of ramifications for different people and we’re trying to minimize any negative impact. But this is complicated and people here are still trying to figure out the implications.”

In a best-case scenario, passing a conformity law would take a minimum of 60 days, Campbell predicted. In the worst case, it could get caught in the budget debate and be tabled until June. The state is facing a $12.4-billion shortfall, and tax conformity would cost roughly $44 million in 2002 and more in subsequent years, according to an analysis by the Franchise Tax Board.

*

All Workers in State Could Be Affected

Public employees aren’t the only ones touched by the tax law impasse. Just about any worker in California--and in a dozen other states in similar circumstances--who has a 401(k) or an IRA could be affected. Some already are.

Some companies won’t allow employees to boost retirement plan contributions above 2001 levels because California law hasn’t been adjusted to the higher federal levels.

Mutual funds and investment companies are allowing California residents to boost their contributions to self-directed retirement plans--such as IRAs and Roth IRAs--to the new, higher levels allowed under federal law. But some who already have made those contributions--unaware that the increased contributions don’t comply with state law--worry about what will happen if California law isn’t changed or the changes aren’t made retroactive.

“People are left in limbo, “ said Charlene Hyde, a Santa Monica speech pathologist. “I already contributed $3,500 to a Roth IRA. Am I a criminal for having contributed too much? I want to comply with the law. But it is very difficult to know what to do.”

*

(BEGIN TEXT OF INFOBOX)

Not in Line

Tax laws in 13 states haven’t been revised to incorporate the recent changes in the federal tax code:

* Arizona

* Arkansas

* California

* Hawaii

* Idaho

* Indiana

* Iowa

* Kentucky

* Massachusetts

* New Jersey

* North Carolina

* South Carolina

* Wisconsin

Conforming

These states conform with some of the new federal tax provisions, such as higher limits on retirement plan contributions:

* Alabama

* Georgia

* Maine

* Mississippi

* Oregon

* Pennsylvania

* West Virginia

U.S.-California Conflicts

These federal tax law changes for 2002 don’t conform with California tax law:

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

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

* Maximum 457 retirement plan deferrals rise 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