Washington--If the House-approved tax-reform bill becomes law with its rule on contributory pensions intact, the measure would change the tax status of the vast majority of school employees who retire in the next few years.
According to the General Accounting Office, 94 percent of state pension plans--most of which include teachers--are contributory, compared with 7 percent of private-sector plans. Most local-government plans are also contributory.
In the past five years, following a ruling by the Internal Revenue Service, some states have allowed local school districts to convert to a system in which employees contribute pretax dollars, thus deferring the taxation of the income until retirement. But this is a recent phenomenon, and employees nearing retirement under such systems are due credit for many years of after-tax contributions.
The implications of the new formula for taxing pensions would depend on an individual’s finances, other income, age at retirement, pension contributions, annuity amount, and other factors.
Employees who are planning on substantial taxable income immediately after retirement--from individual retirement accounts, continued employment, or other sources--would be most penalized by the new rule.
The following examples of “typical” retirees are intended to illustrate the potential impact. The new House-passed tax rates are used throughout and retirees are assumed to be single with no dependents or itemized deductions.
The average employee who retired from an urban school system in Ohio in 1985 was 60 years old and had 30 years of service, with a final average salary of $27,320, according to Victor Miller of the state teachers’ pension system. This retiree would receive a pension of $1,315 a month and withdraw his or her lifetime contribution in 30 months.
Under the current rule, assuming the retiree has a life expectancy of 74 years, the annuity would remain untaxed until the third year of retirement, when federal income taxes would be $441. Under the House-passed bill, this income would be taxed at $1,202 a year, for a total of $3,606 over three years.
Also, in each of the next 11 years, this typical Ohio school retiree would enjoy a small tax exemption under the House bill, 8which would roughly balance the higher taxes owed earlier--unless inflation averaged more than 4.5 percent a year over the period or the retiree died earlier than expected.
But these future exemptions would most likely fail to compensate for additional taxes the retiree would pay, at higher rates, on other taxable income at the outset of retirement.
For example, with $4,500 a year in additional income in each of the first three years, under the House plan the retiree would pay total federal taxes of $5,634 over the period, instead of $1,116 under the current rule.
In Pennsylvania, a hypothetical school administrator, retiring at age 62 with 30 years of service and a final average salary of $40,000, would be eligible for a pension of $2,000 a month, according to Nell Knight, a spokesman for the Pennsylvania public-school employees’ retirement system. Under the current rule, he or she would pay no taxes in the first year after retiring and $1,057.50 in the second year (assuming withdrawal of contributions in 18 months).
Under the House provision, this retiree would pay $5,525 over the same period. Tax exemptions over the next 10 years would probably make up the difference, but only if the retiree had little other taxable income.
For example, with additional income of $14,000 in each of the first two years, this Pennsylvania retiree’s taxes would total $5,370 under the current rule, as compared with $15,272 if the House provision becomes law. The latter figure includes taxes of $2,737 on a portion of the retiree’s Social Security benefits because, without the current exemption, the taxable income would surpass the $25,000 threshold in both years.
A hypothetical North Carolina teacher retiring at age 65 with 15 years of service and a final average salary of $20,000 would receive a pension of $462.50 a month, according to a formula provided by Dennis Ducker of the state teachers’ retirement system.
This income is low enough that the retiree would owe no taxes, under current law or under the House bill, assuming he or she had no other taxable income.
Under the current rule, this pensioner could receive first-year income of up to $4,162 (in addition to Social Security) without paying taxes, as compared with $416 under the House plan.--jc
