Don't Sweat Untaxed Disability Payments

Rest assured there is absolutely no group of city retirees who owe the United States Treasury "hundreds of millions of dollars in Federal taxes," as The Post reported on March 25, 2009. How absurd can you get! The situation is really a non-event but because of the shoddy reporting on the part of The Post, I feel that I must respond.

A contributory retirement system is one that is funded by both employer and employee contributions. All of the five public-employee retirement systems of the City of New York are contributory systems. The employee's contributions account is used to fund an "annuity," while the employer's contributions account funds a "pension." Taken together they fund a "retirement allowance."

The pension amount is fully taxable because it is comprised of employer contributions. The annuity amount may be fully or partially taxable depending on whether or not the employee paid income tax on the contribution before it was invested by the retirement system. Your annual statement should tell you the portion of your contributions account that was invested pre-tax under Section 414(h) of the Internal Revenue Code. The balance of the contributions account (if any) was invested after you paid the tax. The annuity portion derived from Section 414(h) contributions is taxable, while the annuity portion derived from non-414(h) contributions is tax-free. The taxable as well as the tax-free amounts of a retiree's retirement allowance is reported to the retiree and the Internal Revenue Service every January on Form 1099R. All of this detail applies with equal vigor to a recipient of an ordinary disability pension.

Having said all that, disability pensions granted on account of an on-the-job-incurred accident/disease (Duty Disability) are received tax-free because the Internal Revenue Service considers such a payment scheme to stand in the shoes of a Workers' Compensation Act payment schedule. Some recipients of these taxfree pensions (mostly police and fire) also, mistakenly, received tax-free annuities derived from their Code Section 414(h) contributions. Inasmuch as this annuity income is derived from contributions that were made with pre-taxed dollars it should have been taxed but was not, an honest mistake. The Law Department of the City of New York brought the mistake to the attention of the Internal Revenue Service. In order to identify the thousands of retirees (some are no longer with us) who owe the government income tax, the city would have had to research the pension payrolls of the five retirement systems going back about 20-25 years, a monumental task.

Instead, the IRS and the city came to a negotiated settlement as follows: Disability-inthe line-of-duty retirees will start paying income tax on the taxable portion of their annuities on Jan. 10, 2009. All accrued (past) tax liability was forgiven by the IRS in return for the city making a one-time payment of $750,000 to the IRS. The case is closed.

Of Note: It is only about 20-25 years ago that employee annuity contributions were first invested tax-deferred under Section 414(h). Prior to that time, employee contributions were made with after-tax dollars, so 100 percent of the annuity income derived from those contributions was properly received tax-free by the retiree.

Tip: This would be a good time to make sure that you're paying income tax on your annuity income derived from your 414(h) contributions account. Remember: New York, the City of New York and the City of Yonkers do not tax public employee retirement allowances. If you reside in another state, check with that state's taxing authority.

Mr. Frank is a fee-only Retirement Financial Planner and a retired city high school Teacher of Accounting. He can be reached by telephone at (732) 536-9472, or via e-mail at rollover@optonline.net.