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  • Whether You Like It Or Not Retirement Income Is Taxable


    (At this time of the year, this column usually is devoted to taxes, since many of you will be paying income tax on pension and Social Security for the first time, something you must face, although you wish you did not.)


    It is the retiree question whose answer makes the voices in a pre-retirement counseling session turn from normal modulation into higher pitched, sarcastic whines. 


    The question, “Is the pension taxable?” 


    The answer, “Yes.”


    Having now crossed the line into sacred territory, the questioner listens intently to the next statement, expecting and receiving the worst, “And so is your Social Security.”


    Oh well, as the old saying goes, there are two things in life that are certain, one of which is the requirement to pay taxes......and that means whether you are working or you are retired (The other certainty in that phrase is not a subject of this column.)


    And, if having to pay taxes isn’t bad enough, the fact that the Federal government and the State of New Jersey use different methods in arriving at the taxability of retirement income, just adds to the unhappiness of retirees.


    Like it or not, New Jersey retirees are required to pay Federal income tax on pension income, assuming one’s retirement income is large enough to be taxed.


    State income tax is also required of those who continue to reside in New Jersey after retiring.  Retirees living outside New Jersey, on the other hand, are not required to pay New Jersey state income tax on their New Jersey pensions.  (They may, however, be subject to income tax in the state in which they reside.)


    Social Security may be subject to Federal taxation, depending upon the adjusted gross income of the individual or couple.  Social Security, however, is NOT considered taxable income under the New Jersey Gross Income Tax.


    Clearly, then, retirees must be prepared to pay income tax(es) on their pensions at either one level of jurisdiction (Federal) or two levels (Federal and State).


    To begin to understand the tax requirements in retirement, the retiree must review an item sent by the Division of Pensions at, or shortly after, retirement.  This statement contains information about the retiree’s choice of either the Maximum benefit or an optional choice, the name of the option beneficiary (if there is one), the amount of life insurance the retiree will have after retirement and the amount of contributions made by the retiree during the individual’s active career. 


    The contribution information on the statement is divided into two numbers: one represents contributions that were taxed before they were contributed to the retirement system (pre-1987 contributions and any contributions made for the purchase of prior service); the other number represents contributions that were not taxed before they were contributed to the retirement system (regular contributions since January 1, 1987, whose taxability status is established by Section 414H of the Internal Revenue Code).  In virtually all cases, the second number is larger than the first one.  Contributions already taxed by the Federal and State governments (pre-1987 contributions and contributions made for the purchase of prior service) will not be taxed again in retirement. The trick, however, is to know what already has been taxed and what has not been taxed and the manner in which the already taxed dollars will be treated by each governmental entity after retirement.


    The reason for all this manipulation was the 1986 Tax Reform Act, which changed the method of viewing already taxed pension contributions.  Prior to that legislation, all contributions that had been taxed prior to retirement were recaptured by retirees during the first year or two of retirement, and the retiree did not have to pay Federal or State income tax until all the contributions had been recaptured.  This was called the Three Year Rule, because no taxes were due upon the already taxed contributions as long as those contributions were recaptured within three years of retirement.  (Taxes became due, however, as soon as the already taxed contributions were exhausted, even if it took only one year.)  If it took longer than three years to recapture the contributions, another method was used.


    The 1986 legislation eliminated the Three Year Rule at the Federal level.


    It did not eliminate it at the State level.


    Further, in 1987, the State of New Jersey, taking advantage of Internal Revenue Code Section 414h, made regular pension contributions by all New Jersey public employees PRE-TAX dollars for Federal income tax purposes, but not State income tax purposes.  Thus, regular pension contributions to the retirement system made since 1987 have been taxed by New Jersey, but not by the Federal government.


    The result of these changes in taxability of contributions has led to a mess for retirees.


                                               The Federal Situation


    #   Most of the Social Security check (85%) is subject to Federal income tax. 


    #   Most of the pension check is subject to Federal income tax, starting with the first pension check.


    #   A minuscule PART OF EACH PENSION CHECK is not subject to Federal income tax.  In most cases, 90% to 96% of each retirement check IS subject to Federal tax. That is because the Federal government, having eliminated the Three Year Rule, instituted a method of allowing the retiree to recapture the already taxed dollars  over the retiree’s anticipated life span, which is calculated to be between ages 82 and 87 by the Internal Revenue Service. (The exact age is determined by a Federal chart which uses your age at retirement and a life span for that age.)


    The calculation of the non-taxable pension for Federal income tax purposes is made by the Division of Pensions each year during the retiree’s life.  At the end of each year, the retiree receives a form 1099-R from the Division which shows two amounts: (a) the gross pension paid during the year and (b) the taxable pension (for Federal purposes).  The difference between the two is the non-taxable Federal amount for that year.  The yearly non-taxable amount is fixed until the retiree reaches the anticipated life span calculated using the Federal chart.  After that age, the entire pension is subject to Federal tax.


    One further point regarding contributions relates to a retiree dying before fully recapturing the already taxed dollars.  In that case, the estate of the retiree can deduct all the remaining taxed dollars on the income tax filing (Federal and State) that must by made by the estate for the year of the retiree’s death.


                                                        The State Situation


    The State of New Jersey, on the other hand, still utilizing the Three Year Rule, does not tax pensions of retirees still living in New Jersey until all the contributions made by the retiree during his/her educational career have been recaptured (as long as the total contributions are recaptured within the first three years of retirement) since the State has been taxing the entire salary, including the pension contribution money, all along.  (Most retirees recapture all their contributions in the first twelve to eighteen months of retirement.)  After all contributions have been recaptured, the retiree pays state income tax on the entire pension. 


    New Jersey law, however, provides an exclusion of some of a retiree’s pension for retirees age 62 or older, if their New Jersey Adjusted Gross Income (AGI) is less than $50,000 (Single filers) or $100,000 (Household filers).  (This exclusion applies to all retirees living in New Jersey, not just public employees.) In the current filing for 2012 income, a single retiree meeting the age requirement will be able to exclude $15,000 of retirement income from New Jersey income taxation.  A couple (household) filing a joint return will be able to exclude $20,000 from New Jersey taxation, while a married couple filing separately will be able to exclude $10,000 each.  


                                         Withholding or Filing Quarterly


    Finally, let us look at the methods available for paying taxes after retirement, whether those taxes are to be paid to the Federal government only or to both the Federal government and to New Jersey.  Both entities require that taxes be paid throughout the year, either through quarterly estimated payments or through monthly withholding from the pension check.  The choice is left to the individual, and the method chosen need not be the same for both jurisdictions.  (If monthly withholding is the choice of the retiree, the Division of Pensions will withhold taxes for both governmental bodies or for either one.)


    At the time of retirement, the retiree receives information from the Division of Pensions and Benefits relating to income tax withholding from the retiree’s pension.  Included in this information is a statement that states that the Federal government requires that taxes be withheld monthly from the pension check, unless the retiree, in writing, chooses to opt out of withholding.  In that case, the retiree is required to file quarterly estimates with the IRS and make a payment with each quarterly estimate.  A W-4P, a federal withholding form, is included with the information.  On it, the retiree lists the number of dependents that will be used in determining the amount to be withheld.  Of course, if the retiree chooses to file quarterly, the section for listing the number of dependents is left blank.


    The method of paying taxes to the State (if the retiree continues to live in New Jersey) is different because the initial checks a retiree receives are viewed as a return of the retiree’s contributions to the pension system, which, as noted above, have already been taxed by the State.  (For most retirees, this tax-free period lasts from one to one and a half years.)  Therefore, it is not necessary to have New Jersey income tax withheld initially upon retirement.  But, after approximately the first year, when all the contributions have been recaptured, the retiree should file a New Jersey tax withholding form.  This form is voluntary.  However, New Jersey, like the Federal government, requires either monthly withholding from the pension check or quarterly payment of taxes.


    Faced with the two choices, withholding monthly or paying quarterly, most retirees choose the withholding method.