June 12, 2011 posting updated December 3, 2011 to reflect the Michigan Supreme Court ruling discussed at Michigan Supreme Court Upholds Most of Public Act 38 of 2011 (regarding taxation of pension income); Strikes Down Exemptions Phased-Out Based on Income.
In the tax reform package just enacted, in the midst of the historic elimination of the Michigan Business Tax (replaced by the 6% income tax on “C” corporations), we have faced criticism for the changes made to the way pensions are taxed (or not) in Michigan.
We are required to have a balanced state budget, so the questions are always "what is the most fair tax system that has the least impacts on skewing the economy" and "what are the essential services that we must or should fund". Good, intelligent people can have different opinions on such matters but the bottom line in Gov. Snyder's thinking (and agreed upon by a majority of legislators) was that it was not fair for some people to be taxed on their earned income while retirees were exempt from taxes. The fact that previous legislators had catered to seniors for votes did not mean that now our current lawmakers should do the same. We have provided for a reasonable transition period, provided for “household resources” thresholds so that the elderly poor are protected, and allowed those more aged and already retired to continue to be exempt. That appeared to be a reasonable approach so I voted for the tax bill.
What must be kept in mind is that a prime goal of the tax reform was to improve the business climate to create jobs. The tax bills enacted not only relieves the double taxation burden on many small businesses who are significant job creators, but also empowers these businesses to spur additional job growth in Michigan.
Further, the underlying motivation for the change is clear. The percentage of Michiganders who are over 65 is growing rapidly and is expected to grow to over 20% by 2030. Meanwhile, an exploding part of the budget, Medicaid, is significantly affected by the growing nursing home population. To create a structurally sound budget, now and into the future, the “tax expenditure” of the senior exemptions needed to be trimmed. And if we did not do it now, it would be even harder to do in the future when an even higher percentage of the voters would be the special interest group affected by the change.
After the Governor’s initial tax proposal, the input I received from many in the district, including seniors, was that the taxation of pensions would be acceptable as long as there were some income threshold such that the elderly poor were not being taxed on their pensions. $20,000 for a single person and $40,000 for a couple appeared to be what was accepted by most.
The negotiated agreement between the House and Senate leadership and the Governor put in such an income threshold in the form of a “household resources” threshold, but also reduced the impact on seniors in other ways (although it did get more complicated than I feel comfortable with).
The result is a three-tiered system which determines whether retirement income is taxed.
· People born before 1946 will continue to receive the current retirement income exemptions, as well as the personal exemption ($3700), Social Security exemption and the exemption for dividends, interest and capital gains. That is, public pensions will not be taxed. Private pensions will not be taxed if under the current exemption threshold of $45,120 for single filers and $93,240 for joint filers (indexed to inflation). 401(k)s and IRAs will be taxed as under current law. (That is, these are subtractions from income in MI 1040 Schedule 1: (a) Retirement distributions from a 401(k) or 403(b) plan attributable to employer contributions or attributable to employee contributions to the extent they result in matching contributions by the employer and (b) IRA distributions received after age 59½ or described by Section 72(t) (2)(A)(iv) of the IRC (series of equal periodic payments made for life.)
· Taxpayers born between 1946 and 1952 will have the Social Security exemption and the $3700 personal exemption until age 67, but will be taxed on other retirement income (defined as public pensions, private pensions, 401(k)s and IRAs). Taxpayer in this age range can take an exemption of $20,000 for a single return and $40,000 for a joint return against retirement income until age 67. Upon turning 67, they receive a $20,000 single and $40,000 joint senior exemption against all income in addition to Social Security and personal exemptions.
· People born after 1952 receive the personal exemption and Social Security exemption until they turn 67, but will be taxed on other retirement income (defined as public pensions, private pensions, 401(k)s and IRAs). When 67 and older they receive a $20,000 single and $40,000 joint senior exemption against all types of income. This exemption can be taken instead of the Social Security and personal exemptions if it is more beneficial to the filer.
· On a joint return, it is the year of birth of the older spouse that controls the tax treatment of both spouses' pensions.
. For people born in 1946 and after, the retirement income and senior exemptions are phased out if total household resources exceed $75,000 for single filers and $150,000 for joint filers.(Nullified by the Supreme Court.) Public pensions are subject to state taxes as of Jan. 1, 2012. People born before 1946 are not affected by either change.
· Military pensions continue to be exempt regardless of age.
· The current deduction for interest, dividends and capital gains for seniors in the maximum amount of $9,420 single and $18.840 joint is eliminated for all age groups.
· The current additional “over 65” personal exemption of $2,300 is eliminated.
· Seniors may also be affected by the elimination of any Homestead Property Tax Credit if the taxable value of the homestead exceeds $135,000. The Credit will also phase out earlier than currently, between $41,000 - 50,000 of household resources. Further, the percentage of the credit allowable has been changed. Only seniors with household resources of $21,000 or less will qualify for the full 100% credit, with it phased done to the 60% everyone else qualifies for for a senior with household resources of $21,000 to $30,000.
Overall, the tax plan enacted is a net tax reduction for the state which aggressively positions the state to be economically competitive. Despite the expected unhappiness by those who will be negatively affected by the tax reform (and in any reform there will be some “winners” and some “losers”), the question is not the fairness of the changes, but whether the final result is fair. I support the changes we have made.
Disclaimer: This is intended to provide you with a general summary of the new provisions. You should always consult with your tax advisor regarding the application of these change to your particular situation.