The federal tax treatment of IRAs, ROTH IRAs, 401(k)s, and 403(b)s has been the subject of countless books, articles, seminars, and commentary. But, there is precious little regarding the New Jersey state income taxation of these accounts, which is often vastly different. Understanding New Jersey taxation rules is important, not only for distributions made to the account owner during lifetime, but also as part of the owner’s overall estate plan.
Contributions Not Deductible
Many people are surprised to learn that New Jersey does not allow a deduction for contributions to IRAs and 403(b) plans, even if they are deductible for federal income tax purposes. It is only since 1984 that New Jersey began to allow a deduction for employee contributions to 401(k) plans. The New Jersey Division of Taxation explains:
The New Jersey Gross Income Tax Act does not contain any provisions similar to the Internal Revenue Code that allow an individual to deduct contributions to an IRA. Contributions to an IRA are subject to New Jersey Income Tax in the year they are made.
For the reasons described below, it is critical to preserve your tax records showing the amount of New Jersey income tax paid on IRA, 401(k), and 403(b) plans. At the time of distribution, account owners are entitled to exclude from New Jersey taxable income the portion of their retirement accounts on which they have already paid New Jersey income taxes paid in prior years.
For New Jersey income tax purposes, withdrawals from IRAs, 401(k)s, and 403(b)s will generally be deemed taxable to the extent the withdrawal exceeds the amount that has already been taxed when it was contributed. Contributions made before moving to New Jersey are treated the same as if they had been earned while living in New Jersey.
The taxable portion of the withdrawal is a fraction share of the amount withdrawn, determined by dividing the taxable portion of entire account by the total account value. It is critical, therefore, to permanently maintain tax records to be able to determine how much of the account has been taxed and how much has been contributed tax-free. You may overpay if you cannot determine the taxable portion of the distributions. These records are also important for the beneficiaries of your retirement account, who will taxed under the same rules.
The only exception to these rules is for Qualified Distributions from ROTH IRAs, which are not subject to New Jersey income tax. Qualified Distributions are those which are made more than five-years after the first contribution to account and must be made:
- On or after the date on which the individual reaches age 59½;
- To a beneficiary (or the individual’s estate) after the individual’s death;
- To an individual who is disabled; or
- To a qualified first-time home buyer distribution as defined by federal law.
As of 2020, New Jersey completed a four-year process of phasing in a partial exclusion of pension income. Depending on an individual’s total income, qualified taxpayers may be able to exclude a substantial portion of their pension income for New Jersey income tax purposes.
Don’t Forget your Beneficiaries
Distributions to a beneficiary will be partially taxable under the same rules. In addition, New Jersey residents must be aware of the effect of the New Jersey Inheritance Tax, which is applied to 100% of the balance in these accounts. Spouses, lineal descendants (children, grandchildren, etc.), lineal ascendants (parents, grandparents, etc.), and charities are not subject to inheritance tax, but everyone else is. Inheritance Tax rates range from 11% to 16%, depending on the relationship of the beneficiary to the account owner and the value of the estate. For these reasons, planning for these accounts is very important.
There are important differences between the way in which the federal government and the state of New Jersey tax IRAs, 401(k)s and 403(b)s. Those differences have a major effect on lifetime and post-death planning tax and estate planning. Failure to understand and address these issues can increase the overall tax burden during lifetime and after death. Estate planning options, including trusts, should also be considered when passing these accounts to your beneficiaries.
This has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.