State Tax Treatment May Be Different for CARES Act Provisions

Participant communications about coronavirus-related distributions should include language that state tax treatment may vary, or that participants should check with an expert about what state taxes may apply. 

The Coronavirus Aid, Relief and Economic Security (CARES) Act created a new emergency retirement plan distribution option dubbed the “coronavirus-related distribution,” or “CRD” for short. A CRD can be drawn from an employer-sponsored retirement plan or from individual retirement accounts (IRAs) in any amount up to $100,000. Under the terms of the CARES Act, the normal 10% penalty tax levied on early plan distributions by the IRS is waived. Furthermore, the individual taking a CRD can spread the reported income over three years for tax purposes, and the distribution also can be repaid within three years to avoid taxation.

But a law alert from global law firm Eversheds Sutherland suggests retirement plan participants should be warned that state and local tax treatment of these distributions may be different. Adam Cohen, partner at the firm and leader of its employee benefits team, who is based in Washington, D.C., says many of the changes to retirement plan legislation in the past 20 years related more to qualified plan requirements rather than individual taxation of participants. However, the creation of Roth 401(k)s/IRAs in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) is one example of when there was a need for state and local taxation to get in line with federal taxation.

Following Hurricane Katrina, the Katrina Emergency Tax Relief Act of 2005 (KETRA) also allowed for expanded retirement plan distribution and loan provisions with favorable federal tax treatment, but Cohen says state and local tax treatment was not a big focus since the hurricane only affected participants in a limited number of states.

Cohen explains that many states continuously conform to the Internal Revenue Code, adopting changes as they occur, and others conform as of a specific date and every couple of years the legislature gets together and updates the date as of which the state conforms. He adds that some states may also “pick and choose” what provisions of the federal tax code with which they want to comply.

Of particular note, as Cohen and his co-authors point out in the law alert, “While historically a rolling conformity state, New York’s FY 2021 Budget Act temporarily adopts fixed conformity as of March 1, through January 1, 2022, for purposes of the both the state and New York City personal income taxes.”

The alert notes, “As a result of this fixed conformity, New York became the first state to take action to decouple from the CARES Act, including the three-year ratable income inclusion for coronavirus-related distributions from retirement plans. Therefore, if a plan participant subject to New York income tax takes a coronavirus-related distribution, he or she may be surprised to learn that for New York state and local income tax purposes, the distribution is taxed 100% in 2020, rather than the federal ratable treatment.”

Cohen says, as they have in the past with similar legislation, eventually most state legislatures will conform to federal tax treatment of CRDs, but until they reconvene, it is “up in the air.” He also notes that “in the past, states have recognized the issue will be hard to fix after people file their taxes.”

When legislatures reconvene, “there may be a patchwork of states that conform, but over time, my best guess is it will fill in,” Cohen says.

In the meantime, Cohen suggests communications to plan participants about CRDs include language that state tax treatment may vary, or that participants should check with an expert about what state taxes may apply. If plan sponsors and advisers want to be more specific, they could look up the law and say what clearly applies in a particular state, but that is harder to do for a “fixed conformity” state. “Communications could say a state doesn’t recognize federal tax treatment at this time but that may change later in the year,” he says.  

One final note Cohen makes is that the same issue exists for the CARES Act provision allowing employers to offer certain help with employee student loan repayments. Under the law, employers can make payments up to $5,250 toward employees’ student loans through end of this year, and the payments do not have to be reported as taxable income for federal income tax purposes. Participant communications about the student loan payments should include warnings about state tax treatment similar to what’s included in communications about CRDs.