The truth about the tax cut
The Bush tax cut was cheered by many, but you may save less than you think.
NEW YORK (CNN/Money) - When Congress passed the 2001 Tax Relief Act, it made saving for college and retirement more tax-friendly than ever.
Among other things, it increased annual contribution limits this year for employee savings plans and individual retirement accounts, offered those over the age of 50 the chance to "catch up" on tax-deferred retirement savings, and gave public pensioners the ability to roll distributions from their section 457 retirement plans into IRAs -- thereby extending the shelf life of their tax-deferred savings.
But many states have not yet updated their own tax laws to conform with the new federal laws.
Of the 41 states that charge an income tax, 22 automatically incorporate most of the federal tax changes into their own state tax codes. In the remaining states, however, tax laws are amended as of a certain date (and not every year) or are adopted on a piecemeal basis.
Until your state conforms with the new federal tax rules, you could be liable for state taxes, even penalties, if you try to take advantage of higher contribution limits or new rollover rules for tax-sheltered accounts on your 2002 returns next year.
(Some taxpayers in certain states could also pay more in estate taxes, in spite of the federal reduction. Click here for more.)
Under the worst-case scenario, said Ed Ferrigno, vice president of Washington affairs for the Profit Sharing/401(k) Council of America, ignoring your state's current tax codes could cause all of your contributions for the year to be disqualified and therefore subject to state taxes.
"There certainly is a lot of political pressure for states to adopt the new federal tax codes," said John Barry, chief economist for the Tax Foundation, a nonprofit organization providing tax policy analysis. "But there is no law that requires them to do so."
Because of uncertainty over what states will do, many private and public retirement plan administrators are taking a wait-and-see approach.
"Although conforming legislation is expected in most states, there are a number of companies that are currently not allowing their employees to go to the new limits," said Mary Turk-Meena, principal in the employee benefits tax group for Deloitte & Touche.
Mary Willett, director of supplemental retirement plans for Wisconsin's department of employee trust funds said questions remain over whether the state will conform. As such, her office is telling individuals that they can make higher contributions, but that if the laws aren't updated by the time they reach $8,500 (the old limit for 457 plans) "we won't let them contribute any more."
Willett adds, "If someone wants to take their 457 money and roll that over we can't prohibit them from doing so, but we are making them sign a waiver that says they recognize that they could be subject to state taxes."
Why this year is unusual
These types of discrepancies between state and federal law are usually temporary.
"Typically the [federal government] makes a tax change and the states conform. It's a routine event," said Alysoun McLaughlin, federal budget and taxation policy specialist for the National Conference of State Legislatures. She points out that many state legislatures begin their sessions in January or February and finish by spring, which means they've only recently had the chance to consider last year's tax law. "The fact that states haven't conformed yet doesn't mean they are not going to," she added.
This year may be a different story, however. According to the National Association of State Budget Officers, adopting these tax cuts will cost states millions of dollars in tax revenue each year. Michigan, for example, is expected to lose $120 million in revenue during the 2002/2003 fiscal year and $179 million the following year.
"If this act had been passed two years ago there would not have been much debate about conformity," said John Logan, senior tax analyst for CCH Incorporated. "But this year, more than 40 states are facing budget shortfalls."
The situation is so severe that some observers say they wouldn't be surprised if even so-called "conforming states" decided to rethink some of the tax changes.
"When there is a major change to the federal system, state legislatures will take a look at it and ask whether they want to conform and what the cost is to the state," said Verenda Smith, government affairs associate for the Federation of Tax Administrators. She says that states have every right to question whether adopting the federal changes is in the best interest of the state. "There are some very, very hard decisions before the states."
While there is certainly the possibility that states will not adopt the new federal tax codes, states are likely to fix their budget gaps first with drastic budget cuts and tax hikes on such things as tobacco and alcohol. Moreover, a number of state legislatures are facing re-election in November. "For them not to adopt the new savings rules is not very feasible politically," said Logan.
What to do if you're in legislative limbo
If you're thinking of taking advantage of any of the higher contribution limits or rollover options, you may want to first take a look at what is going on with your state's legislature. Many are currently in the process of amending their state tax codes. Then you'll want to weigh the pros and cons of making a higher contribution now and waiting for your state to conform.
"We are encouraging our investors to go ahead and invest the higher IRA amounts, which is $3,000 if you are under 50," said Christine Fahlund, a senior financial planner for T. Rowe Price. "If push comes to shove you have until April next year to remove any contributions."
Also consider what you'll pay in state taxes versus what you'll save in federal taxes. If you're in the 27 percent tax bracket, for example, you'll save $27 in federal taxes for every $100 you contribute or roll into a tax-sheltered plan. If your state has a 6 percent income tax, you'll pay $6 in taxes, but you're still $21 ahead.
"It probably doesn't make sense to postpone making the extra deductions because even in a high state-tax situation the federal benefit still outweighs the state cost," said Martin Nissenbaum, National Director of Personal Income Tax and Retirement Planning, Ernst & Young, noting that when states conform, they typically make their changes retroactive. In that case, you would owe no state taxes anyway.
Of course, while you're waiting for your state legislature to take action, it wouldn't hurt to let them know what you think. This is an issue that needs to be addressed right away, said Kathyrn Ricard, vice president of retirement and pensions for the American Council of Life Insurers. "The taxpayer should argue that it's critical that they be able to plan for their retirement and not be a burden to the state down the road," she said.
Click here to search for your state's legislative site.