Which state should I report 457(f) distribution?

[Mikemcna]

I currently reside and work in KY, which has a 5% state income tax.  I will receive a mandatory 457(f) distribution (tax-exempt employer contributions not previously taxed) in 2020.  I am considering moving residency to TN, which has no state income tax, and ultimately retiring there (although after the distribution date).  

If I change residency (with all that is required) I know my regular wages will continue to be taxed in KY under a non-resident return.  Can I exclude the 457(f) distribution from KY taxes and claim that as a TN “wage” for state income tax purposes?

[Critter]

The retirement distribution is only taxable in your state of residence when it was paid out. 

[Mikemcna]

That's what I thought, but the W2 with the 457(f) distribution will be issued by a KY employer with all other wages earned in KY.  And that is appropriate for those wages.  But the 457(f), if it appears on that W2, will likely result in a state audit (KY) as it will be large and a large tax avoidance if it can be claimed in another state.  So I am really hoping to build an audit defense here and not finding state-level documentation that is helpful.  The federal (IRS) guidance isn't particularly helpful either, referring to this as ordinary income and wages.  By the way, in this case the 457(f) is not deferred wages, it is strictly employer contributed plus gains while held in the account.

[SteamTrain]

@dmertz 

......are you knowledgeable on the special 457(f) distribution reporting requirements?

(and if it is taxed by KY even if the person has already become a TN resident?)

[Mikemcna]

I am not knowledgeable on either.  Can you point me in the right direction?  (I’m on the receiving end of the distribution, not the paying end).  I’m particularly concerned about the KY/TN issues.

[SteamTrain]

The "dmertz" you see above my question?

......That is a request for that person to respond if he knows the details.  (that question was meant for him, and the notice pops up in his account)).  Dmertz is particularly knowledgeable about all kinds of retirement distribution situations. But, he has not been online for the past 3 hrs...and may not be back and see this until tomorrow, or Monday....so you may have to wait some more for a response.

[dmertz]

I'm not familiar with 457(f) plans.  Since this nonqualified deferred compensation plan is reported on a W-2 in for the later of the year it was received or the year it is no longer subject to a substantial risk of forfeiture, it seems like it would be income in the same state as the state in which regular wages would be taxed if such regular wages were paid at the moment that the deferred income became reportable, that is, when the deferred compensation became no longer subject to forfeiture, KY in this case, I think.  But that's just a guess.  Ask the employer.

[Mikemcna]

@dmertz I agree with your logic to this point.  However, if the 457(f) participant dies, the spouse receives the payment as of the date of death.  It couldn’t be wages for the spouse since she never worked for the employer nor was a plan participant.  (For the participant is really isn’t wages either because, in this case, there is no deferred salary in the plan - it is only employer contributions.  457(f) can be used for deferred comp, but not in this case.). And so, if she had established residency in another state as of the date of death/payment, I think she would have a strong argument that KY had no claim to the payout as in-state wages.

Extending that logic, it would seem any participant/beneficiary should be treated the same, ie no KY tax if residency is established elsewhere (even in continuing employment).

[Mikemcna]

Employer is fully contained in KY (all locations) and simply puts this on the W2 with KY as the state.  Only two employees, both residing in KY, have received payouts in the history of this plan, and neither the employer nor I have found anything definitive (reliable) at the state level.  

[dmertz]

I think I misunderstood the circumstances.    My previous comment addressed taxation of money that was contributed by the employer.  If money is being distributed to you from the plan, I would expect that only the gains portion of the distribution (perhaps proportionate amounts of employer contributions on which taxes have already been paid and gains) would be taxable income and would be income taxable in the state of residence at the time of the distribution.

[Mikemcna]

Let me back up to clarify (again, there are several flavors of 457(f) but this is how ours works):

Each year the employer makes a contribution to the plan in accordance with plan documents, in my name.  That money is invested similar to a 401(k) among several possible funds in our case.  The total of contributions and growth cliff vests at age 62, or if terminated without cause, or if I die or am disabled.  Otherwise it is forfeited, even if I retire the day before my 62nd birthday.  The balance has to be paid out shortly after the 62nd birthday.

The IRS is clear that the payout in this case is all ordinary, and treated like wages on the W2.  So the federal is set.  If I could avoid that, I would!

The state is the fuzzier part, because there doesn’t seem to be much/anything published on this specifically.  Basically the question is if I reside in one state (TN) and work in another (KY) and it is the KY employer who pays the 457(f) balance to me at age 62, which state can tax it (or how do I defend excluding it from KY wages)?

[dmertz]

Those details help clarify the nature of the distribution.  There are two components to the money in the plan, the basis in non-elective deferred compensation contributed by the employer and the investment gains.  I think it's possible that the two components are taxable in different states as I mentioned above, the basis in KY in and the gains in TN, but I can't be sure; I guess I really can't be of much help.  Which state taxes which portion will be established by how the employer reports it on the W-2, so this is really a question for the employer.

[Mikemcna]

Thanks @dmertz. I appreciate you helping with this.