WHAT THE CPA MISSED

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Several readers of my post “A Tax Season Story” have asked me what the CPA missed that would generate such alarge tax liability.While the IRS has not used the “ThreeYear Method” for recovering after-tax employee contributions to a pension planfor decades, the State of NJ still does. The instructions for the NJ-1040tells us - “if you will recover yourcontributions within three years from the date you receive the first paymentfrom the plan, and both you and your employer contributed to the plan, you mayuse the Three-Year Rule Method to determine your taxable pension income”. Under this method you “exclude your pension and annuity paymentsfrom gross income until the payments you receive equal your contributions tothe plan.  Until that time, the amountsyou receive, because they are considered your contributions, are not taxable andshould not be reported on your return.” The taxpayer in the situation hadbegun to receive his pension from the NJ Division of Pensions in late 2010.  While his after-tax employee contributionsare amortized over an expected life on the federal return, the taxpayer qualifiedfor contribution recovery under the Three-Year Rule Method on his NJ-1040. NJ will only treat employeecontributions to a 401(k) plan as pre-tax for state income tax purposes.  Because the pension plan from which thetaxpayer was receiving distributions was a 403(b) plan all employeecontributions to the plan were treated as “after tax” for NJ purposes.  NJ state wages were never reduced by theemployee contributions. The CPA reported on the preliminary 2011NJ-1040 the same amount of pension income that was reported on the federal Form1040.  This would have resulted in anexcessive overpayment.  The taxpayer wasstill working (not for the State of NJ) and his spouse also did, with a muchhigher salary, so the exempt pension distribution would have been taxed at avery high rate. Included in the taxpayer’s copy ofhis 2010 NJ-1040 was a statement from me that indicated his total after-taxcontributions, the amount recovered in 2010, and the carryforward to 2011.  The taxpayer provided the CPA was the copiesof his 2010 federal and state returns. A very expensive mistake! FYI – the offices of the CPA were inNJ and not NY. TTFN