Bailey Decision Concerning Federal, State and Local Retirement Benefits

As a result of the North Carolina Supreme Court's decision in Bailey v. State of North Carolina, North Carolina may not tax certain retirement benefits received by retirees of the State of North Carolina and its local government or by the United States government retirees (including military) for each retirement plan if the retiree has five or more years of creditable service as of August 12, 1989. The exclusion also applies to retirement benefits received from the State's 401 (k) and 457 plans if the retiree had contributed or contracted to contribute to the plan prior to August 12, 1989. The exclusion does not apply to local government 457 plans, 403(b) annuity plans, or to retirement benefits paid to former teachers and state employees of other states and their political subdivisions. You can view the list of qualifying retirement plans in the North Carolina Department of Revenue Individual Income Tax Bulletins. A retiree entitled to exclude retirement benefits in arriving at North Carolina taxable income should claim a deduction on Form D-400 Schedule S, Part B – Deductions from Federal Adjusted Gross Income, line 8, for the amount of excludable retirement benefits included in federal adjusted gross income. The total deductions from federal adjusted gross income entered on Form D-400 Schedule S, line 12, also needs to be entered on Form D-400, line 9. A copy of Form 1099-R or W-2 received from the payer must be attached to the return to support the deduction.

Note: The "special separation allowance" paid to retired law enforcement officers pursuant to G.S. 143-166.41 and reported on Form W-2 does not qualify for exclusion under Bailey.

Distributions from most types of retirement plans may be rolled over into another retirement plan or into an IRA. Because rollover distributions lose their character upon rollover, all distributions from a qualifying Bailey retirement account in which the employee / retiree was "vested" as of August 12, 1989, are exempt from State income tax regardless of the source of the funds contained in the account. Conversely, qualifying tax-exempt Bailey benefits rolled over into another retirement plan or to a traditional IRA lose their character and would not be exempt upon distribution from the other plan unless the plan is a qualifying Bailey retirement account in which the employee was vested as of August 12, 1989. See Directive PD-04-1.

Participants in the Optional Retirement Program for State Institutions of Higher Education (ORP) should refer to Directive PD-00-1 to determine the taxability of distributions from ORP. In addition, participants in the Federal Thrift Savings Plan should refer to Directive PD-99-2. It is possible for a participant in the Plan to be vested in the employee component but not in the employer fixed percentage component as of August 12, 1989.

Income Tax Treatment of a Rollover Distribution to a Roth Account

While a rollover distribution to a traditional IRA is generally not taxable at the time of rollover and the subsequent distributions from the traditional IRA are generally taxable, a rollover distribution to a Roth account is generally taxable at the time of rollover and the subsequent distributions from the Roth account are generally not taxable. If the rollover to a Roth account is from a qualifying tax-exempt Bailey retirement account, the rollover distribution is exempt from State income tax and deductible on the State return to the extent the rollover distribution was included as income on the taxpayer’s federal income tax return.

Overpayments

Taxpayers who have paid North Carolina income tax on their rollover distributions from a qualifying tax-exempt Bailey retirement account into a Roth account on any of their 2008 through 2013 State income tax returns may file an amended State income tax return to request a refund of taxes overpaid if the tax year is in statute.

For additional information, please see Directive PD-14-1, Bailey v. State of North Carolina; Emory v. State of North Carolina; Patton v. State of North Carolina.