25 May How do taxes work on these retirement plan distributions?

Q. I have basis in my traditional IRA. I converted a part of the account to a Roth IRA and my advisor explained using the “general method” for recovering both federal untaxed and New Jersey taxed contributions, and I’ve done this for additional conversions and also for my Required Minimum Distributions. Then I learned about the three-year rule to recover basis in three years. And now the CARES Act waived 2020 distributions and I can do another partial Roth IRA conversion. Can I use the three-year rule?
— Figuring

A. This is complicated.

Generally, basis is created when you contribute to your retirement plan and it is not deductible for New Jersey state income taxes.

In New Jersey, this applies when you contribute to a retirement plan such as a 403(b) plan, a 457 plan, a SEP, or any other retirement plan contribution other than a 401(k), said Patricia Daquila, a certified financial planner and certified public accountant with Lassus Wherley, a subsidiary of Peapack-Gladstone Bank, in New Providence.

“This is because 401(k) contributions up to the federal annual deferral limit are not included in your New Jersey taxable wages,” Daquila said. “However, 401(k) contributions made prior to Jan. 1, 1984 and contributions made beyond the annual federal deferral limit will create basis in your retirement plan.”

In addition, she said, contributions that are made to a retirement plan — other than a 401(k) up to the annual deferral limit — prior to moving to New Jersey are considered to have been previously taxed by New Jersey and create basis.

These contributions when made are not deductible from your New Jersey gross income and therefore create tax basis in your retirement account. In many cases, your basis could be different for federal tax purposes than it is for New Jersey, she said.

As you mentioned, New Jersey offers two methods to recover the basis in your retirement plan — the general method and the three-year rule method.

“The three-year rule must be applied if you can recover all your contributions within 36 months from the date that you receive your first payment from the plan, and both you and your employer have contributed to the plan,” Daquila said. “If you use the three-year method, then you do not report any income for New Jersey tax purposes until you have recovered all your contributions.”

Many times, teachers who begin collecting their New Jersey state pensions can apply the three-year rule, she said.

The other method is the general rule method.

“You must use that method if you cannot recover your contributions within the first 36 months from the date your first payment was taken from the plan or if your employer did not contribute to your plan,” she said. “With the general rule method, part of your pension is excludable for New Jersey income tax purposes and part is taxable every year. The part that is excludable is your contributions to the plan.”

She said there is a Worksheet B in the NJ 1040 instructions that can help you with your calculation.

Daquila said in your situation, you already started taking distributions from your plan in 2014, which is six years ago and you used the general rule.

“Unfortunately, it is too late to change to the three-year rule method,” she said. “You would have to be able to recover all your contributions in the first three years and start the three-year rule on the date that you received your first distribution.”

As always, check with a tax advisor about the specifics of your situation.

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This story was originally published on May 25, 2020.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.