WHAT THE CPA MISSED

Several readers of my post “A Tax Season Story” have asked me what the CPA missed that would generate such a large tax liability.

While the IRS has not used the “Three Year Method” for recovering after-tax employee contributions to a pension plan for decades, the State of NJ still does.

 

The instructions for the NJ-1040 tells us - “if you will recover your contributions within three years from the date you receive the first payment from the plan, and both you and your employer contributed to the plan, you may use the Three-Year Rule Method to determine your taxable pension income”.

 

Under this method you “exclude your pension and annuity payments from gross income until the payments you receive equal your contributions to the plan.  Until that time, the amounts you receive, because they are considered your contributions, are not taxable and should not be reported on your return.”

 

The taxpayer in the situation had begun to receive his pension from the NJ Division of Pensions in late 2010.  While his after-tax employee contributions are amortized over an expected life on the federal return, the taxpayer qualified for contribution recovery under the Three-Year Rule Method on his NJ-1040.

 

NJ will only treat employee contributions to a 401(k) plan as pre-tax for state income tax purposes.  Because the pension plan from which the taxpayer was receiving distributions was a 403(b) plan all employee contributions to the plan were treated as “after tax” for NJ purposes.  NJ state wages were never reduced by the employee contributions.

 

The CPA reported on the preliminary 2011 NJ-1040 the same amount of pension income that was reported on the federal Form 1040.  This would have resulted in an excessive overpayment.  The taxpayer was still working (not for the State of NJ) and his spouse also did, with a much higher salary, so the exempt pension distribution would have been taxed at a very high rate.

 

Included in the taxpayer’s copy of his 2010 NJ-1040 was a statement from me that indicated his total after-tax contributions, the amount recovered in 2010, and the carryforward to 2011.  The taxpayer provided the CPA was the copies of his 2010 federal and state returns.

 

A very expensive mistake!

 

FYI – the offices of the CPA were in NJ and not NY.

 

TTFN