PD-03-1 Bailey v. State of North Carolina; Emory v. State of North Carolina; Patton v. State of North Carolina

On June 7, 2001, President Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16). This Act made numerous changes with respect to pension portability. In general, beginning in 2002, distributions from most types of retirement plans may be rolled over into another retirement plan or into an IRA.  Because of the increase in rollover flexibility, especially for governmental §457 plans, the Department has issued this Directive to address the impact rollovers have on the tax-exempt status of state, local, and federal governmental retirement plans that qualify under the Bailey settlement.

Under the Bailey settlement, state, local, and federal governmental employees and retirees who were “vested” in a qualifying retirement system as of August 12, 1989, do not pay North Carolina income tax on their retirement benefits in future years. This means that retirement benefits are exempt from North Carolina income tax if the benefits are distributed from a qualifying Bailey retirement account in which the employee/retiree was “vested” as of August 12, 1989. If the employee/retiree rolls over any of the qualifying tax-exempt benefits into another retirement plan, the benefits retain their tax-exempt status only if the retirement plan into which the benefits are rolled over is also a qualifying Bailey retirement account in which the employee/retiree was “vested” as of August 12, 1989. Rollovers to IRAs will always result in a loss of the tax-exempt status since IRAs do not qualify under the Bailey settlement.

Example: Taxpayer A was “vested“ in both the state’s Deferred Compensation Plan (§ 457 plan) and the state’s Supplemental Retirement Income Plan (§ 401(k) plan) as of August 12, 1989. In 2002, Taxpayer A elected to roll over the balance in his Deferred Compensation account into his Supplemental Retirement Income account. Future distributions from Taxpayer A’s Supplemental Retirement Income account will be exempt from North Carolina income tax.

Example: Taxpayer B was “vested” in the state’s Deferred Compensation Plan (§ 457 plan) as of August 12, 1989; however, he was not vested in the state’s Supplemental Retirement Income Plan (§ 401(k) plan) as of that date. In 2002, Taxpayer B elected to roll over the balance in his Deferred Compensation account into his Supplemental Retirement Income account. Future distributions from Taxpayer B’s Supplemental Retirement Income account will be subject to North Carolina income tax, except for the $4,000 deduction provided by G.S. 105-134.6(b)(6).

Example: Taxpayer C was “vested” in the state’s Deferred Compensation Plan (§ 457 plan) as of August 12, 1989. In 2002, Taxpayer C elected to roll over the balance in his Deferred Compensation account into an IRA. Future distributions from Taxpayer C’s IRA will be subject to North Carolina income tax, except for the $2,000 deduction provided by G.S. 105-134.6(b)(6).

If a qualifying tax-exempt Bailey retirement account includes rollover distributions from IRAs or other retirement plans (other than another qualifying tax-exempt Bailey retirement account), only a portion of the retirement benefits is exempt from North Carolina income tax. To determine the portion of each distribution that is exempt from state income tax, the employee/retiree must determine the portion of the account balance at the time of retirement that is attributable to any rollover distributions from IRAs and other retirement plans (other than another qualifying tax-exempt Bailey retirement account). For simplicity, the portion attributable to rollover distributions from IRAs and other retirement plans (other than another qualifying tax-exempt Bailey retirement account) does not include any amounts earned subsequent to rollover. The following formula is used to determine the percentage of the retirement benefits received each year that are exempt from state income tax:

(B-R) divided by B equals E. 
“E” is the exempt percentage.
“B” is the account balance at the time of retirement. 
“R” is the portion of account balance at the time of retirement attributable to any rollover distributions from IRAs or other retirement plans (other than another qualifying tax- exempt Bailey account). 

 

Example: Taxpayer X was “vested“ in both the state’s Deferred Compensation Plan (§ 457 plan) and the state’s Supplemental Retirement Income Plan (§ 401(k) plan) as of August 12, 1989. In 2002, Taxpayer X elected to roll over the balance in his Deferred Compensation account into his Supplemental Retirement Income account. Future distributions from Taxpayer X’s Supplemental Retirement Income account will be 100% exempt from North Carolina income tax.

Example: Taxpayer Y was “vested” in the state’s Deferred Compensation Plan (§ 457 plan) as of August 12, 1989. In 2003, Taxpayer Y ceases his secondary employment with a private company and elects to roll over the $25,000 balance in his § 401(k) plan with the private company into his state Deferred Compensation account. When Taxpayer Y retires in 2010, his state Deferred Compensation account has a balance of $50,000. Future distributions from Taxpayer Y’s state Deferred Compensation account will be 50% exempt from North Carolina income tax under the Bailey settlement. [($50,000 - $25,000) / $50,000 = 50%]. The portion of the distributions that are subject to tax (50%) will be eligible for the $4,000 deduction provided by G.S. 105-134.6(b)(6). Therefore, if Taxpayer Y receives distributions totaling $5,000 from his Deferred Compensation account during 2011, $2,500 would be exempt from state income tax under the Bailey settlement and the remaining $2,500 would be excludable from state income tax under G.S. 105-134.6(b)(6).

Example: Taxpayer Z was “vested” in the state’s Supplemental Retirement Income Plan (§ 401(k) plan) as of August 12, 1989. In 2003, Taxpayer Z elects to roll over $20,000 from his IRA into his Supplemental Retirement Income account. When Taxpayer Z retires in 2020, his Supplemental Retirement Income account has a balance of $60,000. Future distributions from Taxpayer Z’s Supplemental Retirement Income account will be 67% exempt from North Carolina income tax under the Bailey settlement. [($60,000 - $20,000) / $60,000 = 67%]. Therefore, if Taxpayer Z receives distributions totaling $25,000 from his Supplemental Retirement Income account during 2021, $16,750 would be exempt from state income tax under the Bailey settlement and $4,000 would be excludable from state income tax under G.S. 105-134.6(b)(6).