The sound-bite for cutting taxes for seniors in Michigan was simple. Roll back the retirement tax put in place in 2012, according to Gov. Gretchen Whitmer, and put $1,000 back in the pockets of 500,000 households.
The reality, like many things when it comes to taxes, is that many Michigan retirees could be stumped when they end up staring at complex retirement-related tax calculations for their 2023 state income tax returns next year and afterward.
“Retirees may need to consult the advice of a qualified tax preparer (to) ensure you are able to deduct the maximum amount of retirement benefits,” according to the Treasury website.
How will Michigan retirees handle taxes in 2023?
The good news? We’ve got a year ahead to analyze the issues. And retirees might not find the modest changes as difficult as they think on 2023 state returns. For all taxpayers, the Michigan income tax rate has dropped to 4.05% in 2023, down from 4.25% in 2022.
The bad news? Many retirees will be looking at extra work to figure out if they can get a better break under the new rules. Some might not be looking at much or any of a state tax break when they file their returns next year. The big savings associated with the move to “repeal the retirement tax” will be down the road for many retirees as new, more accommodating limits gradually phase into place.
Lisa Pohl, principal and director for state and local tax for Rehmann in Grand Rapids, said her firm is advising its clients that they don’t need to change their estimated tax payments for the state of Michigan or state withholdings simply based on the new rules ahead for 2023.
If they’re too optimistic, and decide to withhold less for taxes, some could end up unexpectedly owing money next spring when they file the 2023 state income tax return. Better to be safe, she said, given that we’re working with a new tax situation.
“The safest bet is pretend like nothing happened,” she said.
Retirees have options
Upfront, retirees need to understand that they still can opt to deduct their pension and retirement income just as they did in 2022 using the old rules, which involve a tier structure based on when you were born. Or they can select to use new rules, what’s called a “phase-in subtraction” when addressing any taxes owed on their retirement income.
Tax experts say retirees won’t be worse off going forward but they need to run more numbers to make sure they’re selecting the best option for their situation each year, as new rules phase into place.
Pohl, at Rehmann, said many, especially older retirees, could end up using the same formula for retirement income for their 2023 Michigan income tax return as they did on the 2022 return to get the best tax savings initially.
One significant shift that kicks in now: The new state law does exempt pension income for public police officers and firefighters, county correction officers, and state troopers and sergeants from the Michigan state income tax beginning in 2023.
“Clearly, the big winners right now for 2023 would be police and firefighters. They get the exemption right away. Everybody else is more of a phased in approach for the next couple of years,” said Paul Finegold, tax partner at Baker Tilly in Southfield.
It’s bound to be confusing
Already, I’ve heard from several retirees who are worried that new pension rules, signed into law March 7, are confusing. They fear that they could lose out on tax breaks that exist now. But tax experts stress that’s not the case.
“The new law has not eliminated any rules for calculating the allowable retirement subtraction. Instead, a taxpayer who receives retirement or pension income will have more options for calculating their allowable retirement subtraction beginning tax year 2023,“ according to a statement from Treasury.
The change in the retirement tax rules did not apply at all to 2022 tax returns.
Make no mistake, your eyes will glaze over when you see the new phase-in charts for subtracting pension income for 2023, 2024, and 2025 state income tax returns. Many retirees will be deciding if they should opt to use old rules or new rules, as allowed, during this time.
“Some might be worried that if they make the wrong choice, it might cost them,” Finegold said. “And it’s just new. It is confusing.”
Taxpayers, of course, would be able to amend a return if they discovered later that they made a significant mistake. But who wants to do that? It would feel better to do it right the first time.
Some details are outlined in a Michigan Treasury explainer that’s online at www.michigan.gov/taxes. The Michigan Office of Retirement Services has an FAQ online that is useful. Expect to see worksheets next tax season.
Finegold said he wouldn’t be surprised if Treasury provides additional resources such as an online calculator at some point to help taxpayers understand the new law.
The state will have new tax forms available next year that should make things clearer, too.
I wrote about the pension tax back in 2012 as the pension tax went into place and it was extremely complicated then. Unraveling it now, seems even more cumbersome. It is extremely hard to give general guidelines on how much money individuals might save — and it could be good to have a conversation with your tax professional this year to walk through some scenarios.
The latest change phases out Michigan’s retirement tax over four years and ultimately delivers an average of $1,000 to 500,000 households, the state Treasury said, and it equalizes the exemption on both public and private pensions.
Retirees, especially younger baby boomers, faced a sizable tax burden on their pensions and what money they withdrew from tax-deferred retirement savings plans. The rules needed to be changed so retirees would take less of a tax hit and be able to use more of their retirement income to cover their own expenses.
A contrived, age-based system went into place in 2012 after Republican Gov. Rick Snyder successfully pushed through a controversial plan in Lansing to tax the pension and 401(k) incomes of millions of retirees.
Back in 2012 when the rules changed in Michigan, those born in 1945 or earlier locked in favorable tax breaks. But a cacophony of rules crashed in on other retirees based on when they were born and then suddenly, the rules changed again when they turned age 67.
The tax burden didn’t fall equally.
Under the previous law, those born in 1945 or earlier — say someone who is turning 78 or older in 2023 — saw the most favorable tax treatment. They weren’t hit by the state’s tougher pension rules that kicked off in 2012. A sizable portion of their retirement income is not taxed at the state level in Michigan.
“The law that was just passed is meant to get everyone else into their shoes over the next four years,” said Pohl, who is a long-time member of the Michigan Association of CPAs state and local tax task force.
Under the new law, the idea is to treat younger retirees favorably, too, so it will no longer matter what year you were born and whether it’s a private or public retirement benefit.
Not that it will be easy to adjust going forward. But the tax savings will be sizable, exceeding even the $1,000 estimate for some retirees, Pohl said.
Back in 2012, Snyder ended what many viewed as another set of complex tax-exemption rules on pension income. Michigan’s Treasury then said that Snyder’s plan would raise about $900 million from about 1 million taxpayers. Based on that, the average added cost to retirees was expected to be about $900 a year. But the real cost varied for individuals.
Don’t panic or expect easy answers
The real savings in Whitmer’s plan will vary for individuals, too.
What’s important to understand is that in general more retirement income — pensions and 401(k) withdrawals — will be protected from being taxed at the state level over time.
For the 2026 tax year and after, all retirees, no matter when they were born, will be able to deduct their retirement or pension benefits up to 100% of a set amount that typically would have only applied to those born in 1945 and earlier. The maximum set amount changes each year.
Baker Tilly’s Finegold noted that the new law will impact the 2023 tax year. But he said taxpayers need to realize that the new law will not take effect until 90 days after the close of the current legislative session, which could be in December. If so, the new law might take effect sometime in March. At this point, he said, some taxpayers may not want to file their 2023 returns in early January or February but instead wait until later when the new law takes effect.
For the 2023 tax year and forward, those who are born in 1945 and earlier — someone who is 78 or older — there is no change. They will see the same benefits as they did under the old law. Those born in 1945 and earlier — known as Tier 1 — still get the best benefits. For the 2023 tax year, their limit for retirement income that isn’t taxed at the state is $61,518 for single returns and $123,036 for joint returns.
These amounts can change every year. Each tax year, the state notes, the maximum amounts allowed are adjusted by the percentage increase in the U.S. Consumer Price Index for the previous calendar year.
Retirees who are younger need to pay more attention as rules change over time. Different rules will be in place in 2023, 2024 and 2025 to build up the change in 2026 and after.
When you’re choosing what works best, you can’t just ask another retiree what they’re doing. Much depends on your age and your financial situation. Talk to a tax professional for guidance. If married, know that the age of the older spouse determines the age category that applies to any state tax on pensions.
On 2023 state income tax returns, for example, those born in 1959 and after are not eligible for a deduction.
Those born from 1946 to 1952 — someone who turns 71 to 77 this year — can choose between the maximum deduction of $20,000 for single returns and $40,000 for joint returns under the previous rules or up to 25% of the maximum amount of the allowable deduction for those born before 1946. For the 2023 tax year, that would equal a deduction of $15,379.50 for a single return and $30,759 for a joint return.
If born from 1953 through 1958, you could deduct up to 25% of the 2023 maximum. By contrast, most taxpayers born in 1953 and after had no pension subtraction in 2022. But after reaching age 67, individuals are entitled to subtract the Michigan Standard Deduction against all income. This deduction for this group is reduced by the personal exemption amount and other factors.
The phase in formula, based on the new law, will be up to 25% of the maximum allowed for 2023, up to 50% in 2024, up to 75% in 2025 and 100% in 2026. And that phase in will apply to a wider group of retirees based on ages.
Under the previous law, once someone born in 1946 or later turns 67, they could subtract the Michigan Standard Deduction against all income. For a single person, the standard deduction was up to $20,000. For a married couple filing a joint return, the standard deduction was up to $40,000. Then, they might get more of a tax break on their retirement income.
A point to understand, though, is that under the previous law someone who is born in 1953 or after would receive a much smaller benefit from the standard deduction once they turn age 67. That’s because their deduction then must be reduced by the personal exemption, any taxable Social Security benefits included in federal adjusted gross income and military pay and retirement or pension benefits received for serving in the U.S. Armed Forces and Michigan National Guard or as part of the Railroad Retirement Act.
Next year, as retirees prepare to file their 2023 state income tax returns, some might not see much change in tax savings from the 2022 return.
When filing a 2023 return, for example, someone who is 72 in 2023 and married filing jointly could take the greater of $40,000 or 25% of the maximum allowed for those who were born in 1945 or earlier. For the first year, many in that age group likely will use the old $40,000 and not see added savings. But the new limits that phase in will offer more advantages down the line.
Don’t be discouraged. Pay attention to the rules for your age group. Know that in 2026, the state tax system isn’t age-driven for retirees and the rules will be less complex.
Bottom line: The phase-in formula is so small on 2023 returns that most people will get a better tax break by sticking to the old plan, Pohl said. So there might be some simplicity there. Ultimately, though, many people will benefit from a bigger tax break in just a few years.
This article originally appeared on Detroit Free Press: Rolling back Michigan’s retirement tax triggers plenty of questions, confusion