Life Insurance Annuity: Michigan Income Exemption?

In Michigan, a subtraction may be allowed on the Michigan return for qualifying distributions from pension plans. Retirement and pension benefits include most income reported on Form 1099-R for federal tax purposes, including defined benefit pensions, IRA distributions, and most payments from defined contribution plans. For a pension distribution to qualify for the Michigan subtraction, it must comply with the distribution rules under its plan. For example, for employer plans, an employee must retire under the provisions of the plan, and the pension benefits must be paid from a retirement trust fund.

Certain distributions reported on Form 1099-R are not considered retirement or pension benefits and are taxable. These include all distributions from 457 plans and distributions from 401(k) or 403(b) plans sourced from employee contributions and their earnings if unmatched by the employer.

Qualifying distributions from pension plans

Pension plans can be created by private companies or public entities, and they each have their own rules for receiving pension distributions. For a pension distribution to qualify for the Michigan subtraction, it must comply with the specific distribution rules under its plan.

Employer Plans

For both public and private employer plans, the following criteria must be met:

• The employee must retire under the provisions of the plan.
• Pension benefits must be paid from a pension trust fund.
• The payment must be made to either the employee or the surviving spouse.
• Payments made to the surviving spouse are only deductible if the employee qualified for the subtraction at the time of death.

Individual Plans

Individuals may have pension accounts created under various sections of the IRC that may or may not be part of an employer's plan. To qualify for the Michigan pension subtraction, the distributions must meet the requirements set forth in the relevant section of the IRC.

Individual Retirement Account (IRA) IRC 408 Distribution Requirements

• Distributions after the death of the participant may only be subtracted by a surviving spouse if the distributions qualified as a subtraction for the participant at the time of death.
• Distributions must be a series of equal periodic payments made for life under IRC 72(t)(2)(A)(iv). Distributions from a Roth IRA are not included in AGI and are not subtractable on the Michigan return.

Senior Citizen Annuity IRC 72 Distribution Requirements

• The recipient must be a senior citizen.
• The distribution must be received from a retirement annuity policy.

For the purposes of the retirement annuity subtraction, a senior citizen is defined in MCL 206.514(1) as an "individual... who is 65 years of age or older at the close of the tax year. The term also includes the un-remarried surviving spouse of a person who was 65 years of age or older at the time of death."

K) and 403(b) Plans

If all the contributions are made by the employee, or if the employee makes contributions exceeding the amount mandated by the plan to elicit employer contributions, then any distributions attributable to those employee contributions will not qualify for the pension subtraction.

Keogh or HR 10 Plans for the Self-Employed

Distributions are usually not made until a participant separates from service, the plan is discontinued, or the participant reaches age 59½.

Distributions That Do Not Qualify for the Pension Subtraction

• Deferred compensation plans that allow the employee to set the amount of compensation to be deferred and do not prescribe retirement age or years of service.
• Commercial annuity policies (unless the payments are made for life to a senior citizen).
• Premature separation, withdrawal, or discontinuance of a plan prior to the earliest date the recipient could have retired under the provisions of the plan.
• Payments received as an incentive to retire early unless the distributions are from a pension trust.
• Eligible distributions received by a beneficiary of the decedent except for the surviving spouse.
• Distributions that are sourced from rollovers from plans or contributions that do not qualify (e.g., IRA distributions that are sourced from rollovers from a 457 plan).

Retirement and pension benefits

The primary requirement for a retirement distribution to qualify for the Michigan subtraction is that the taxpayer must retire under the provisions of a retirement plan. Both employer plans and individual plans have specific rules for receiving pension distributions, which must be adhered to for a retirement distribution to qualify for the Michigan subtraction.

Tier Structure Subtraction

MCL 206.30(9) outlines limitations to the retirement subtraction. If the retiree receives a qualified pension distribution, the allowable pension subtraction is calculated based on the date of birth of the taxpayer (for single/married filing separate returns) or the oldest spouse (for married filing a joint return). Per these requirements, retirees are divided into three tiers.

Tier 1 – Taxpayers Born Before 1946

Retirees may subtract all qualifying pension benefits received from federal or Michigan public sources. The subtraction of public sources of pension income derived from other states is limited to private retirement maximums. Private retirement benefits are subtractable up to certain limits, which are adjusted for inflation.

Tier 2 – Taxpayers Born Between January 1, 1946, and December 31, 1952

Taxpayers born between 1946 and 1952 are generally not eligible for a pension subtraction under this option in 2023. After reaching age 67, individuals are entitled to subtract the Tier 2 Michigan Standard Deduction against all income.

Tier 3 – Taxpayers Born After January 1, 1953

Most taxpayers born after 1952 have no pension subtraction in 2022. After reaching age 67 (on or before December 31, 2022), individuals are entitled to subtract the Michigan Standard Deduction against all income. This deduction is reduced by the personal exemption amount, taxable Social Security benefits included in AGI, and amounts claimed on Schedule 1 for military pay and certain retirement or pension benefits.

Qualified Fire, Police, and Corrections Retiree Subtraction

A special provision was implemented for certain fire, police, and corrections retirees. Beginning in tax years on or after January 1, 2023, retirees may fully deduct retirement benefits received from Michigan service as a public police or fire department employee, state police trooper or state police sergeant, or corrections officer employed by a county sheriff. There is no limitation to the amount of public benefits deductible for these retirees. Private benefits may be deducted up to the private pension limits, but any public retirement deduction claimed reduces the maximum private retirement deduction.

Phase-In Subtraction

The maximum retirement subtractions under the Phase-In Method apply to both private and public benefits combined and are available to retirees based on their year of birth, beginning with 1946. The eligible birth years expand each year until 2026, when everyone born after 1945 will be eligible for a retirement subtraction of qualified distributions. The subtraction amounts are based on a phase-in of the private pension limits, which are adjusted annually based on the United States Consumer Price Index.

Michigan Income Act

The Michigan Income Tax Act, MCL 206.1 et seq., is the legislation that governs individual and fiduciary income tax in the state of Michigan. The Act sets out the rules and requirements for income tax, including rates, deductions, and exemptions. For the 2023 tax year, the income tax rate for individuals and fiduciaries in Michigan was generally subject to a 4.25% tax rate. However, this rate may be reduced to 4.05% if certain conditions are met, relating to the percentage increase in general fund revenue from the previous fiscal year.

The Michigan Income Tax Act also provides guidelines for retirement and pension benefits, including subtractions and distributions. The Act allows for a subtraction on the Michigan return for qualifying distributions from pension plans, including private and public employer plans, and individual accounts. To qualify for the Michigan pension subtraction, distributions must comply with the distribution rules under the specific plan. For example, the employee must retire under the provisions of the plan, and the payment must be made to either the employee or the surviving spouse.

The Act also outlines different options for calculating the allowable pension subtraction, including a Tier structure, a Phase-In Subtraction, and a special provision for certain fire, police, and corrections retirees. These options take into account factors such as the date of birth of the taxpayer, the type of pension (private or public), and the amount of benefits received.

It's important to note that the rules and regulations under the Michigan Income Tax Act can be complex, and taxpayers should consult a qualified tax professional or refer to the official website for the most up-to-date information.

Form 1099-R distribution codes

Form 1099-R is used to report income on your federal tax return. It is sent to you no later than January 31 after the calendar year of the retirement account distribution. The form includes the following information:

• Box 1: Total amount of distribution from a retirement plan or annuity
• Box 2: Taxable amount of the distribution as reported by the payer
• Box 4: Amount of federal income tax withheld
• Box 7: Distribution code, which describes the type of distribution
• Box 9b: Investment for a life annuity in a qualified plan or a 403(b)

Code 1: Early distribution, no known exception. This distribution is subject to a 10% penalty.

Code 2: Early distribution, exception applies. This distribution is not subject to the 10% early distribution tax. This code is used if the participant has not reached age 59 1/2 and the distribution is due to one of the following:

• Separation from service in or after the year the participant turned 55
• A permissible withdrawal under an eligible automatic contribution arrangement (EACA)
• A distribution due to an IRS levy

Code 7: Normal distribution. The distribution is after age 59 1/2 and includes RMDs.

Code 8: Corrective refunds taxable in the current year. Use this code for corrective distributions of excess deferrals, excess contributions, and excess aggregate contributions, unless Code P applies (taxable in the prior year).

Code A: May be eligible for a 10-year tax option. This code is for participants born before January 2, 1936, or their beneficiaries, indicating that the distribution may be eligible for the 10-year tax option for lump-sum distributions.

Code B: Designated Roth account distribution. Use this code for a distribution from a designated Roth account.

Code E: Distributions under the Employee Plans Compliance Resolution System (EPCRS). Use this code for 415 corrections.

Code G: Direct rollover and direct payment. Use this code for a direct rollover into another qualified plan or in-plan Roth conversion.

Code H: Direct rollover of a designated Roth account distribution to a Roth IRA. Use this code for a direct rollover of a distribution from a designated Roth account to a Roth IRA.

Code L: Loans treated as deemed distributions under section 72(p). Use this code for deemed distributions. Do not use it for loan offsets with a full distribution.

Code M: Qualified Plan Loan Asset. Use this code for outstanding loan amounts on distributions for separation from service.

Code P: Corrective refunds taxable in the prior year. This code indicates that the monies are taxable in the tax year prior to the one reported on the 1099-R form.

Code U: Dividends distributed from an ESOP under section 404(k). Use this code for a distribution of dividends from an employee stock ownership plan (ESOP) under section 404(k). These are not eligible rollover distributions.

Retirement and pension benefits chart

Retirement and pension benefits are taxable based on the recipient's date of birth. The following benefits are not taxed, regardless of date of birth:

• US Military pensions
• Michigan National Guard pensions
• Railroad Retirement benefits
• Rollovers not included in the Federal Adjusted Gross Income (AGI)

Recipients Born Before 1946

For 2022, you may subtract all qualifying retirement and pension benefits received from public sources, and may subtract private retirement and pension benefits up to $56,961 if single or married filing separately, or up to $113,922 if married filing jointly.

Recipients Born Between January 1, 1946, and December 31, 1952

If the older spouse (if married filing jointly) was born during this period and has reached the age of 67, you are eligible for a deduction against all income and will no longer deduct retirement and pension benefits. The deduction is $20,000 for a return filed as single or married, filing separately, or $40,000 for a return filed as married, filing jointly.

Recipients Born Between January 1, 1953, and January 1, 1956

All retirement (private and public) and pension benefits are taxable to Michigan, unless one of the following applies:

Taxpayers born between January 1, 1953, and January 1, 1956, should not file Form 4884. Instead, taxpayers may be eligible for a Tier 3 Michigan Standard Deduction. This deduction is up to $20,000 for a return filed as single or married filing separately, or up to $40,000 for a married filing jointly return.

Recipients Born After January 1, 1956

The older spouse (if married filing jointly) was born after January 1, 1956, received retirement benefits from employment exempt from Social Security, and was retired as of January 1, 2013. You may subtract up to $35,000 in qualifying retirement and pension benefits if single or married filing separately, or $55,000 if married filing a joint return. If both spouses on a joint return qualify, the maximum subtraction increases to $70,000.

Frequently asked questions