State Income Tax Consequences of an IRA Contribution

By Jeffery Levine, IRA Technical Expert  

Follow Me on Twitter: @IRAGuru4EdSlott

Just about 24 hours ago, the wheels of my plane touched down in Dallas, Texas, site of this week’s Ed Slott’s Elite IRA Advisor Group and Master Elite IRA Advisor Group Conferences.

Texas is a great place to visit. If you haven’t been yet, I’d highly recommend it. It’s also not a bad place to call home, especially since it’s one of just seven states that doesn’t have a state income tax (Alaska, Florida, Wyoming, Nevada, South Dakota and Washington are the other six).

With no state income tax to worry about, Texas residents don’t have to worry about the state tax impacts of making IRA contributions. Since there is no state income tax, a deduction for making an IRA contribution is irrelevant. Plus, when IRA distributions are made in the future, Texas residents will only owe federal income tax on those distributions (assuming the Texas’ tax laws remain the same).

If you happen to live in one of the other 43 states, figuring out the state income tax consequences of making an IRA contribution is likely to be a bit more taxing (pun definitely intended).

Thankfully, many of the 43 states that impose a state income tax follow the federal income tax rules for IRA contributions. Take New York, for instance. If you live in New York, the state income tax rules governing the taxation of your IRA contributions are essentially the same as those on the federal level. In other words, if you get a deduction for making an IRA contribution on your federal income tax return, you’ll generally get one on your New York State income tax return as well.

Other states make things even more complicated by abandoning or modifying the federal income tax rules for IRA contributions. Massachusetts is a good example of this. Massachusetts, like most states, imposes a state income tax. However, unlike most states, Massachusetts does not follow the federal income tax rules for IRA deductions. Instead, no IRA deduction is allowed at the state level.

The result?I f you live in Massachusetts, or a state with similar rules, and make an IRA contribution, you could end up with IRA money that has a split personality. On the one hand, you could get a current tax deduction on your federal income tax return, leaving future distributions of those funds subject to federal income tax (when those distributions take place). On the other hand, since no deduction would be allowed for your IRA contribution at the state level, you’d have basis (after-tax money) for future state income tax purposes only. Provided you keep accurate records and fill out the appropriate forms, portions of your future IRA distributions should be state income tax free.

Most people pay close attention to the effect their IRA contributions have on their federal income tax return, but if you live in one of the 43 states that has its own state income tax, you should be aware of how those contributions will affect your state income tax bill as well, now and in the future. If you aren’t sure of the specific rules in your state, it’s usually a good idea to start by asking a knowledgeable financial advisor or tax professional.