Growing focus on taxing pension income


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

The idea drew the wrath of many senior citizens, and groups representing that constituency, who argued they had based their retirement plans on the assumption pension income would not be subject to state income taxes. While “one should not change the rules in the middle of the game” might be a good argument, it doesn’t hold water for those who have yet to retire. For most workers today, there will be no such thing as traditional pension income or defined benefit plan since those have become too costly for most employers to fund. The cost of its defined benefit pension plan was cited as a reason General Motors declared bankruptcy during the recent recession.

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 retirement. The amount paid was based on years of service and the employee’s record of earnings. The plans were common, the longevity of retirees was rather limited. Most retirees lived seven to 10 years after retirement. However, as retirees began living longer, as a result of a healthier lifestyle, less physically demanding jobs and advances in medical science, pension plans had to pay out more benefits, requiring greater employer contributions.

Recognizing this changing trend, the federal tax laws were amended to encourage employers to use what is now known as defined contribution retirement plans. With these plans, an employee elects to defer some of his before-tax income into a savings account that is allowed to grow tax-free. In some cases, the employer matches the employees’ contributions as a way of providing an incentive to employees to save for retirement. However, when a person draws his 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 defined contribution plans are subject to state income taxes while those who are beneficiaries of a defined benefit pension plan are not subject to tax. One group of retirees is continuing to pay for education and social services while another group of retirees is not.

The inequity will become even more pronounced as 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 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 made by an 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.

Lowell L. Kalapa is president of the Tax Foundation of Hawaii.Ever since the administration put forth the idea of taxing pension income a couple years ago, the issue has drawn increased discussion, especially as other taxes have been increased to make up for the state’s budget shortfall.

The idea drew the wrath of many senior citizens, and groups representing that constituency, who argued they had based their retirement plans on the assumption pension income would not be subject to state income taxes. While “one should not change the rules in the middle of the game” might be a good argument, it doesn’t hold water for those who have yet to retire. For most workers today, there will be no such thing as traditional pension income or defined benefit plan since those have become too costly for most employers to fund. The cost of its defined benefit pension plan was cited as a reason General Motors declared bankruptcy during the recent recession.

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 retirement. The amount paid was based on years of service and the employee’s record of earnings. The plans were common, the longevity of retirees was rather limited. Most retirees lived seven to 10 years after retirement. However, as retirees began living longer, as a result of a healthier lifestyle, less physically demanding jobs and advances in medical science, pension plans had to pay out more benefits, requiring greater employer contributions.

Recognizing this changing trend, the federal tax laws were amended to encourage employers to use what is now known as defined contribution retirement plans. With these plans, an employee elects to defer some of his before-tax income into a savings account that is allowed to grow tax-free. In some cases, the employer matches the employees’ contributions as a way of providing an incentive to employees to save for retirement. However, when a person draws his 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 defined contribution plans are subject to state income taxes while those who are beneficiaries of a defined benefit pension plan are not subject to tax. One group of retirees is continuing to pay for education and social services while another group of retirees is not.

The inequity will become even more pronounced as 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 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 made by an 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.

Lowell L. Kalapa is president of the Tax Foundation of Hawaii.