Q. I am a money manager and one of my clients has a fairly substantial IRA under my management. He is a retired executive and five years ago he rolled his 401(k) and cash balance plan under my management. He received a 10-year payout, so he hasn’t needed to touch his IRA. He turns 70 1/2 this year, so he will be subject to required minimum distributions.
Decades ago he worked for the state of North Carolina and has a small amount of money in one of the state retirement plans. For simplification, he wants to roll this into his IRA. We called the number indicated to initiate a direct transfer on a speakerphone in my office.
They asked him if he was familiar with the Bailey Act, of which neither of us were. They then went on to explain that he was covered under this act and therefore all of his distributions from the N.C. retirement plan would not be subject to state tax. So I advised him not to transfer the money out of the state plan.
The representative then asked him if he had any other qualified retirement plans or IRAs containing funds from qualified plans. I told them that he had an IRA rollover valued at more than $2 million, but that this had nothing to do with his work for the state and was accumulated while working for XYZ Corp.
They then told him that he could transfer the IRA into the state retirement plan and all withdrawals from the plan regardless of when and where the funds were accumulated would be free of state taxes.
I told my client I would do some research and get back to him. It’s difficult for either of us to believe that he may be able to avoid ever paying state tax on $2 million just because he worked for the state for a few years back in the 1980s.
Even with the new flat rate of 5.8 percent, if this is true, I feel I must encourage him to move the IRA from under my management to his old state retirement plan. Assuming no growth, that’s a $116,000 savings to him if he doesn’t have to pay any state tax! I’m hoping you will tell me that the representative we spoke with is wrong.
A. Sorry, but the representative was correct. The North Carolina Supreme Court’s decision in Bailey v. State of North Carolina in 1998 resulted in certain retirement benefits received by retirees of the state of North Carolina and its local government or by United States government retirees to be exempt from state income tax if the retiree had five or more creditable years of service as of Aug. 12, 1989.
The tax exemption also applies to distributions from the State’s 401(k) and 457 plans if the retiree had contributed or contracted to contribute to the plan before Aug. 12, 1989. The entire case is pretty interesting to read; the following is a very condensed version:
A class-action lawsuit was initiated by the plaintiffs against the state of North Carolina. The plaintiffs were protesting the fact that they were required to pay income taxes on their state retirement benefits. From the inception of the plans until Aug. 12, 1989, benefits from these plans were exempt from state income tax.
In the trial, testimony and exhibits established that innumerable communications were made to plaintiff public employees both orally and in writing throughout their careers that their retirement benefits would be exempt from state taxes.
The plaintiffs asserted that they relied on this information and saw this as a benefit of working in the public sector. The court concluded that the plaintiffs had a contractual relationship with the retirement systems that included the tax exemption of benefits derived from their retirement plans.
A fellow adviser, John F. Mitchell with Northwestern Wealth Management, and I have voiced our opinions about the unfairness of including funds from other sources under the tax-exempt Bailey Act but, as of yet, to no avail. We don’t have a problem with exempting retirement funds that were part of the Bailey Act from state tax but see no reason retirement monies earned from non-state careers are exempt by merely rolling the funds to the state plan, but they are.
The Economic Growth and Tax Relief Reconciliation Act of 2001 made numerous changes with respect to the portability of pensions. EGTRRA allowed rollovers from IRAs to workplace retirement plans, but it didn’t require plans to accept rollovers. Since the state of North Carolina accepts rollovers, funds from any source can end up in a qualifying Bailey retirement account.
Since funds lose their character upon rollover, all distributions from a qualifying Bailey retirement account in which the employee/retiree was vested as of Aug. 12, 1989, are exempt from state income tax regardless of the source of the funds contained in the account.
Allowing retirement distributions from money earned in the private sector to be exempt from state income tax simply because someone has an old qualifying Bailey retirement account doesn’t seem fair to other taxpayers.
A letter sent out by North Carolina’s state 401(k) plan indicates that qualified assets transferred into the plan, regardless of source, will become exempt from all state income taxes. Retirees covered by the Bailey Act are not only being asked about monies from outside sources when they call to initiate transfers, they are receiving letters soliciting the funds!
Furthermore; if a Roth conversion is made using qualifying tax-exempt Bailey funds, the amount converted is not only exempt from state income tax; it is also deductible on the state income tax return to the extent it was taxed as income on the federal income tax return!
Going forward, the lost tax revenue will only increase because of the number of baby boomers retiring. Perhaps the state should consider discontinuing the acceptance of rollovers from the private sector into its retirement plans.
This year (May 2014) began a two-year restatement window for defined contribution retirement plans. It would be the perfect time to address a plan design change and disallow this practice.
For more information and a list of qualifying retirement plans, visit: http://www.dornc.com/taxes/individual/benefits.html.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624