Michigan Pension Tax-Updated
Historically, Michigan allowed an exemption for pension income. For those with private pensions (e.g., 401k plan from GM or an Individual Retirement Account), the State allowed a $45,842 exemption in 2011 ($91,684 for joint filers) from taxable income. For public pensions (i.e., government pensions), the exemption was unlimited—there was no tax on public pension income regardless of amount.
While the pension tax was working its way through the legislative process, the original plan was to subject seniors’ entire pension income to Michigan’s 4.35% income tax. This caused a bit of a stir. The pension tax, in its final form, applies different tax rules to three brackets.
The brackets are:
- Those born before 1946
- Those born between 1946 and 1952
- Those born after 1952
On a joint return, it is the year of birth of the older spouse that controls the tax treatment of both spouses’ pensions.
BORN BEFORE 1946
Those born before 1946 will see no change in how their pension income is taxed. For 2012, private pension income up to $47,309 is exempt for single filers and $94,618 for joint filers. Public pensions are exempt regardless of amount. Social Security income is fully exempt from Michigan tax. Seems simple so far, but wait…
BORN BETWEEN 1946 AND 1952
Phase 1: Before the Taxpayer Reaches Age 67
If a taxpayer is born between 1946 and 1952 and is under 67 years old, the exemption amounts are changed to $20,000 for a single return and $40,000 for a joint return regardless of whether the income is from a private or public pension. Social Security income is exempt. Railroad pension income is exempt. Military pension income is exempt.
Phase 2: After the Taxpayer Reaches Age 67
If a taxpayer is born between 1946 and 1952 and is 67 years old or older, the exemption amounts remain at $20,000/$40,000 but apply to both pension and non-pension income. This provision helps seniors with low pension income because they now have a large exemption that can apply to non-pension income such as wages or business profit.
Social Security income is fully exempt from Michigan tax. Social Security income recipients are still eligible to use the $20,000/$40,000 exemption amounts to other types of income.
Recipients of railroad pension income and military pension income have a choice. They can either:
- take an unlimited tax exemption for railroad pension income or military pension income OR
- claim the $20,000/$40,000 exemption amounts
When the law originally passed, the $20,000/$40,000 exemption amounts were completely phased out if Household Resources exceed $75,000 on a single return or $150,000 on a joint return. However, this phaseout has been ruled unconstitutional by the Michigan Supreme Court because it constitutes a graduated tax. Michigan’s Constitution requires the state to have a flat income tax.
Born after 1952
Phase 1: Before the Taxpayer Reaches Age 67
If a taxpayer is born after 1952 and is under 67 years old, the new law eliminates any exemption of private or public pension. Social Security income, Railroad Pension income, and Military pension income are still exempt from Michigan tax. There is no $20,000/$40,000 exemption available to offset any form of income.
Phase 2: After the Taxpayer Reaches Age 67
If a taxpayer is born after 1952 and is 67 years old or older, the new law allows the $20,000/$40,000 exemption for ALL types of income—public and private pensions, non-retirement income, and Social Security income.
Under this provision, Social Security income, Railroad Pension income, and Military Pension income has to be sheltered by the $20,000/$40,000 exemption amounts.
ALTERNATIVELY: taxpayers may elect to waive the $20,000/$40,000 exemption amounts and instead claim an unlimited exemption for Social Security income, Railroad Pension income, and Military Pension income.
Example: It is 2020, John is 67 years old and he was born in 1953. John has $15,000 in Social Security Income and $30,000 in private pension income. John is married so he is entitled to a $40,000 exemption. John must use $15,000 of his exemption to shelter his Social Security income. John has a $25,000 remaining exemption to shelter his $30,000 pension income. John will pay tax on the remaining $5,000 pension income.
Under the alternative, John would waive the $40,000 exemption amount and fully exempt his Social Security income. However, this would increase John’s taxes. His Social Security income of $15,000 would be exempt, but he must now pay tax on his $30,000 private pension income.
Basically, taxpayers would be better off claiming the $20,000/$40,000 exemption unless their Social Security income, Military Pension income, and Railroad Pension income are greater than the $20,000/$40,000 exemption amount.
If John was born in 1952, his Social Security income would be exempt from tax without having to use his $40,000 exemption. Thus, his full $40,000 exemption would fully shelter his $30,000 pension income.
Tax simplification!!!
Stay tuned for more updates.
Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.
How to Avoid the 10% Penalty on Early Retirement Account Distributions
One issue with investing money in a 401k or IRA is that you generally cannot access the funds until you reach age 59½. If you withdraw funds from these retirement accounts before that age, you will be subject to a 10% penalty on the amount distributed. This penalty is in addition to the federal and state income taxes you’ll pay on the distribution.
Fortunately, the IRS will waive the 10% penalty in certain circumstances. However, even if you meet one of these exceptions, you’ll still have to pay federal and state income taxes on the distribution even if the 10% penalty is waived.
The exceptions are:
- Distributed funds that are rolled over into an IRA or other qualified plan
- Distributions upon death or disability of the account owner
- Distributions that are part of a series of substantially equal periods payments over the life of the account owner or the joint lives of the participant and beneficiary
- Translated into English: when you have a balance in a retirement account, you can calculate an annuity based on the amount in the account payable over your life expectancy (there are a few ways to calculate this annuity). These annuity payments are exempt from the 10% penalty. The annuity has to last through the later of:
- When the account owner turns 59½
- Five years after the date annuity payments began
- Translated into English: when you have a balance in a retirement account, you can calculate an annuity based on the amount in the account payable over your life expectancy (there are a few ways to calculate this annuity). These annuity payments are exempt from the 10% penalty. The annuity has to last through the later of:
- Distributions after the participant’s separation from service (i.e., quitting/laid off/fired), provided the separation from service occurred during or after the year the participant reached age 55 (or age 50 for government plans to a retired police officer, firefighter, or emergency medical services provider).
- This exception applies only to qualified plans, it does NOT apply to IRAs
- Distributions to a former spouse under a Qualified Domestic Relations Order (QDRO)
- Pension benefits are often divided during divorce. To properly comply with pension plan rules, retirement accounts can only be split up pursuant to a QDRO. Otherwise, the plan will have made a disallowed distribution to a nonparticipant. This could jeopardize the tax-advantaged status of the pension plan.
- Once a retirement account has been divided pursuant to a QDRO, the nonparticipant spouse can receive distributions without incurring the 10% penalty. However, the nonparticipant spouse is still subject to the pension plan rules and isn’t entitled to any type or form of benefits that aren’t available in the plan.
- IRAs do not require QDROs to be divided in divorce. The division of the IRA does not cause a distribution; however, amounts withdrawn from the IRAs by either spouse will not be exempt from the 10% penalty if it is a disqualifying distribution.
- Distributions to the extent of deductible medical expenses
- Medical expenses are reduced by 7.5% of adjusted gross income to arrive at deductible medical expenses. Early distributions equal to this amount can be distributed free of penalty.
- Distributions made on account of the IRS’ levy of retirement accounts
The following exceptions apply only for IRAs:
- Distributions equal to medical insurance premiums for workers who have received federal or state unemployment benefits for 12 consecutive weeks. The reduction for 7.5% of adjusted gross income does not apply.
- Distributions used to pay for qualified higher education expenses (college) for the account owner, owner’s spouse or child/grandchild.
- Distributions up to $10,000 for first time homebuyers.
- “First time” doesn’t literally mean “first time.”
- First time homebuyer is defined as not having an ownership interest in a principal residence during the two year period ending on the date the new home is acquired
Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230..
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