Recognition of income in California complicated by COVID IRA distributions

Your Guide to State, Local, Federal, Estate + International Taxation

The CARES Act allowed taxpayers to withdraw up to $100,000 penalty-free from an IRA in 2020 as a COVID-related distribution. In addition, taxpayers were given the option to make an election allowing recognition of income from the distribution over a three-year period beginning in 2020.

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The state of California has conformed to the CARES Act provision and allowed their taxpayers to either recognize all the income in 2020 or spread the income out over three-years. Interestingly, a taxpayer could elect to spread the income out over three years for federal tax purposes but recognize it all in 2020 for California tax purposes (or vice-versa).

However, the recognition of income in California can become complicated if a taxpayer changes residency within the three-year period. Based on guidance provided in FTB Legal Ruling 1998-3 as related to Roth conversions, Spidell tax service thinks California’s Franchise Tax Board would likely allocate to California in a similar way, based on the taxpayer’s actual period of residency in the state. The allocation is calculated based on the number of days the taxpayer resided in California during the year.

For example, assume a taxpayer withdrew $90,000 out of their IRA in 2020 and elected to recognize the income over a three-year period. The taxpayer was a resident of California beginning in 2020 but decided to move to Arizona on September 15. Only a portion of the distribution applicable to 2020 would be taxable by California since they became a nonresident in mid-September. This portion is equal to $21,205 ($30,000 * 258/365 days).

This daily allocation calculation also applies to taxpayers who become new residents of California within the three year recognition period. Assume the same facts as the above example, except the taxpayer was a resident of Arizona and decided to move to California on September 15. In this instance, California would only be able to tax $8,795 ($30,000 * 107/365 days) of the distribution in 2020. Assuming they stay in California the state will tax 100% of the remaining $60,000 distribution over the next two years.

As seen from the above examples, California’s daily income allocation method for these IRA distributions can create some significant tax planning opportunities for those thinking of changing residency within the next couple years.

If you have any questions about recognition of income or think you could benefit from any tax planning in this area, contact your Henry+Horne advisor for more information.

Sabrina Boever