Minnesota's Tax Treatment of Pensions

How does the Minnesota individual income tax apply to pension income?

Minnesota taxes most pension income, whether derived from governmental or private pensions, on the same basis as wages, interest, dividends, and other income. Minnesota allows an income tax subtractions for two kinds of retirement income:

• Military retirement pay, including pensions paid to survivors of military retirees
• A portion of pension income from pension plans that are uncoordinated with Social Security, which are often called "basic plans" in Minnesota

Minnesota also allows a means tested subtraction for federally taxable Social Security benefits—that subtraction is described in more detail here.

The Minnesota tax does not allow an exclusion, deduction, or credit for any other type of pension income.

When did Minnesota exclude public pension income from the income tax?

What was the rationale behind the original exclusion?

The original exclusion likely was based on three considerations.

• First, it was accepted constitutional doctrine in the 1930s that states had no power to tax federal government salaries and pensions under the doctrine of intergovernmental tax immunity. Thus, federal pensions would be beyond the constitutional scope of a state tax. This practice continued, even after the federal court decisions and legislative changes made it clear that states could tax federal employees on a nondiscriminatory basis.¹
• Second, exclusion of Minnesota state government pensions (and later local government pensions) was probably intended to grant equal treatment with federal employees and to provide a convenient, off-budget manner of paying slightly more generous benefits to public retirees.
• Third, the exclusion of railroad retirement benefits was also based on intergovernmental tax immunity. Federal law continues to explicitly prohibit state taxation of some portions of railroad retirement pensions.

How did the exclusion change over time?

During the 1970s the legislature made a series of changes which fundamentally changed the nature of the pension exclusion. These changes can be divided into four categories. The changes were often interrelated. For example, limitations were imposed as a trade-off for expansion of eligibility. The general trend was to expand and equalize the availability of the pension exclusion during the late 1970s. By contrast, the legislature during the 1980s generally restricted the exclusion to limit the revenue loss, to reduce tax rates, and impose more nearly equal tax burdens on pension recipients and other taxpayers (particularly the non-aged).

• The exclusion was extended to recipients of private pensions. Changes in both public and private pension practices during the 1960s and 1970s made it increasingly apparent that limiting the exclusion to governmental employees was anachronistic. The pensions of governmental employees became increasingly generous. More private employers began providing pensions. Governmental employees were increasingly covered by Social Security and the exclusion could not be justified as compensating for the fact that government pensioners did not receive nontaxableSocial Security benefits.
• Limits were placed on the dollar amounts of the exclusion. These limits began at $7,200 per recipient and were expanded ultimately to $11,000.² These restrictions served to equalize somewhat the tax benefits of receiving pension income and to hold down the revenue loss resulting from the exclusion.
• Limits were imposed on the basis of the taxpayer's other income. These restrictions were intended to target most of the benefit of the exclusion to lower income recipients and to reduce the state revenue loss from the exclusion. The legislature also enacted provisions that reduced the exclusion by the amount of nontaxable Social Security and railroad retirement benefits. These restrictions were intended to equalize somewhat the tax burdens of recipients of taxable pensions and nontaxable Social Security benefits. The restrictions proved politically unpopular in the face of charges that they "taxed Social Security" and were quickly repealed in the late 1970s.
• Age restrictions were placed on the exclusion, limiting it to recipients age 65 or older. This age limit did not apply to state and local police and fire pension recipients who often retire at younger ages.

When was the general exclusion last in effect?

A general Minnesota pension exclusion was last in effect for tax year 1986. The exclusion permitted recipients to subtract up to $11,000 of pension income. Pension income was defined as any distribution from a governmental or qualified plan and, thus, included individual retirement accounts, self-employed retirement plans (Keogh Plans), and deferred compensation plans (such as 401(k) plans), as well as standard employer provided pension and profit sharing plans.

The $11,000 maximum applied to single and married joint filers equally.³ The $11,000 maximum was reduced by the amount of the taxpayer's adjusted gross income (AGI) in excess of $17,000. For a married couple, the income offset was based of their joint income. Thus, no pension exclusion was available to an individual or married couple with AGI in excess of $28,000.

As a general rule, only taxpayers aged 65 or older were allowed to claim the pension exclusion. However, an exception was made for recipients of Minnesota state or local pensions for police, fire, and correctional employees. Similar exceptions were not made for law enforcement or correctional retirees who were employed by the federal government.

The tax savings resulting from the pension exclusion equals the taxpayer's marginal tax rate multiplied by the amount of the exclusion. In 1986, with a top marginal rate of 9.9 percent, the pension exclusion would yield a maximum tax savings of $1,089.

Footnotes

¹ See 4 U.S.C.A. § 111 (federal consent to nondiscriminatory state taxation of compensation of federal employees).

² The $11,000 was initially a per recipient limit (i.e., a married couple with each spouse receiving a pension could claim up to $22,000), but was later restricted to a total of $11,000 for a married couple.

³ This result was a vestige of Minnesota's pre-1985 system of separate (or combined) filing for married couples. Under this system, each spouse was allowed a $11,000 exclusion and the income off-set was calculated only on the basis of the spouse's income. With the adoption of joint filing in 1985, the $11,000 amount was applied to the combined pensions of a married couple; the income offset was calculated on the basis of their joint income. This was done regardless of whether they elected to file a separate return.

August 2024