Growing Focus on Taxing Pension Income

by Lowell L. Kalapa, Tax Foundation of Hawaii

Ever since the administration put forth the idea of taxing pension income a couple of years ago, the issue has drawn increased discussion especially as other taxes have been increased to make up for the shortfall in the state budget.

The idea drew the wrath of many senior citizens and those groups which represent that constituency, arguing that they had based their retirement plans on the idea that their pension income would not be subject to state income taxes. While that may be a good argument, that is, one should not change the rules in the middle of the game, it doesn’t hold water for those who have yet to retire. Further, it should be noted that for most workers today, there will be no such thing as traditional pension income otherwise known as a “defined benefit” plan as those types of retirement plans have become too costly for most employers to fund. In fact, it is one reason why General Motors declared bankruptcy during the recent recession. Bankruptcy was the only way it could shed its defined benefit pension plan.

To be clear, defined benefit pension plans are the traditional retirement plans of yesterday where an employer contributed to a fund that then paid out a known sum to an employee upon his or her retirement that was based on years of service and the employee’s record of earnings. At the time, defined benefit plans were common, the longevity of retirees was rather limited with most retirees living seven to ten years in retirement. However, as longevity increased for more recent retirees as a result of healthy living, less physically demanding jobs, and advances in medical science; retirees are living longer. Naturally, that means a pension plan has to pay out more benefits requiring greater and greater employer contributions.

Recognizing this changing trend, the federal tax laws were amended to encourage employers to utilize what is now known as “defined contribution” retirement plans. This is where the employee elects to defer some of his before-tax income into a savings account that would be allowed to grow tax free. In some cases the employer matched the employees’ contributions as a way of providing an incentive to employees to begin saving for their retirement. However, when the contributions and the earnings are drawn for a person’s retirement income, the withdrawals are subject to state and federal income taxes.

As more and more employers shift to these tax deferred savings accounts that include what is known as 401(k) and 403(b) plans, the tax treatment of “retirement” income under Hawaii income tax law will create an inequity. The employee deferred income plans or “defined contribution” plans will be subject to state income taxes while those who are beneficiaries of a traditional “defined benefit” pension plan will not be subject to tax. Even now some retirees who receive their income from the “defined contribution” plans are taxed for state purposes while their neighbor on a “defined benefit” pension is not. To put it more simply, one group of retirees is continuing to pay for education and social services while another group of retirees is not paying for those services.

The inequity will become even more pronounced as more and more employees retire with the “defined contribution” plan as their source of retirement income as employers do away with the traditional “defined benefit” plans.

The equity issue could be addressed by just exempting retirement income from “defined contribution” plans from state income tax, but lawmakers who are pressed for cash probably won’t do that. The other alternative is to gradually impose the state income tax on retirees who receive their retirement income from a “defined benefit” retirement plan.

One approach is to set a high threshold before such “defined benefit” pension income is taxed, so for example the first $50,000 would be exempt and anything beyond that would be subject to tax. Another approach that might be considered is applying the taxation of pension income on a prospective basis such that those who are already collecting pension income would continue to be exempt while those who begin their retirement five years from the date of the change would be subject to the state income tax.

An interesting suggestion was made by one observer is that if pension income is subject to the state income tax, the proceeds should be earmarked to pay down the unfunded liability of the state for its pension and health care programs. Something worth considering.

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