January 2002

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Cal-Tax Commentary 

Greg Turner is Cal-Tax general counsel and legislative director.

With arrival of the new year, the need for California to fully conform to federal retirement investment law cannot be overstated. Urgency legislation should be a top priority as the Legislature reconvenes in January. Otherwise, California employers will be left with a nightmare of complicated and unnecessary accounting problems and taxpayers in this state will be denied the benefits of national retirement law reform.

Even with the state facing significant budget shortfalls, state policy-makers must not turn their backs on taxpayers trying to provide for their own retirement. It is critical for employers and their employees that California quickly conforms fully to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Because the benefits of these enhancements require long-term contributions, California’s non-conformity or even partial conformity this year will work against taxpayers for years to come. Ultimately, the costs to taxpayer and employers will eclipse the estimated revenue loss associated with this change. 

Deleterious effects of non-conformity include the potential for disqualification of pension plans that conform to the federal changes, which potentially means all contributions to a 401(k) after 2001 would be taxable in California. Employee contributions would be taxable and employer contributions would be taxable income to the employee as well. Contributions made under the federal “catch-up” rules would also be taxed in similar fashion.

Contributions to the new federal amounts for Individual Retirement Accounts (IRAs) would produce similar tax consequences.

Aside from the obvious tax ramifications to existing California employees and employers, non-conformity will have a significant and negative effect on California employers trying to recruit talent and trying to locate operations here. California can already be an expensive place to live with relatively high tax burdens. To add reduced retirement funding options to that list will make recruitment and relocation that much harder. Even partial conformity will hamper recruitment and location decisions.

Even if non-conformity does not produce disqualified plans, subjecting only the incremental contributions to California taxation, employers and taxpayers will have to separately track a California basis in pension assets, causing significant administrative costs for plan administrators and the state’s Franchise Tax Board. In addition, there is a high probability that tax liabilities will be overstated or understated in future years if an employee fails to properly account for the separate tax basis in the pension assets. Consequently, even partial conformity would create significant burdens for California taxpayers.

Again, the importance of quickly conforming to the 2001 EGTRRA cannot be overstated. Because of a number of recent Internal Revenue Service directives, pension plan administrators are drafting amendments to existing plans to conform to the IRS requirements. For small employers, the costs of pension plan amendments can be significant. Quick conformity would allow a single amendment process and significantly reduce plan administrative costs.

The EGTRRA included several catch-up provisions to enhance the retirement options for a certain segment of taxpayers. Delays in conformity mean less time taxpayers have to take full advantage of these provisions.

The longer California delays full conformity, the more uncertainty there will be for taxpayers and California will become less attractive as a place to work and do business.

Taxpayers also would benefit from a broader look at conformity to other changes in federal tax law. California has gained little ground in conforming to federal changes in the personal income and corporate income taxes over the past four years. Conformity eases compliance costs for California taxpayers and ensures that California does not undermine the effectiveness of federal stimulus programs when those are part of the federal enactments.