The three states
Most states with an income tax start from federal adjusted gross income, so a contribution that lowers your federal income lowers your state income too. Three states write their own rules for the self-employed.
| State | Sole proprietor or partner: cash balance and profit sharing | Sole proprietor or partner: 401(k) salary deferral | S corporation contribution for its owner |
|---|---|---|---|
| Pennsylvania | Not deductible | Not deductible | Believed not taxed to the owner, as an employer contribution; not confirmed |
| New Jersey | Not deductible | Deductible, up to the federal limit | Believed deductible, not confirmed |
| Massachusetts | Not deductible | Not deductible | Deductible |
Pennsylvania. The Department of Revenue's guide says contributions by a self-employed person, or by a partnership for a partner, are included in the owner's income and are not a business expense. It also says employee contributions to any retirement plan are always taxable, so an S corporation owner's own 401(k) deferrals are taxed in Pennsylvania too.
New Jersey. New Jersey does not allow the federal deduction for Keogh plan contributions, the older name for plans that cover the self-employed, and its regulations say the owner is not an employee of the business. The one exception is a self-employed 401(k): the NJ-1040 instructions let you deduct qualified contributions to it.
Massachusetts. Massachusetts taxes contributions by the self-employed to their own plans. This is based on state directives described in secondary sources; the directives themselves were not reviewed for this page.
What it costs
The contribution still saves federal income tax. What is lost is the state saving in the year you contribute. Pennsylvania's flat rate is 3.07%, so a sole proprietor there who contributes $150,000 pays about $4,605 more in state tax than the same owner in a state that follows the federal deduction. In New Jersey and Massachusetts, with higher rates, the difference is larger.
The cash balance plan calculator applies these rules when you choose one of the three states, and shows the federal and state savings separately.
S corporation owners
The rules above are aimed at the self-employed. An S corporation owner who works in the business is its employee, and the contribution is made by the corporation for an employee. On that reading, the same owner running the same business through an S corporation would get the state deduction in Massachusetts, and probably in Pennsylvania and New Jersey.
Massachusetts is described as allowing it. For Pennsylvania and New Jersey, the treatment of an S corporation's contribution for its own shareholder has not been confirmed at the company level, so treat it as likely rather than settled. Whether it is worth changing how the business is taxed depends on much more than this, including payroll tax on salary. See S corporation owners and talk to your tax adviser.
Getting it back when the money comes out
Because the contribution was taxed going in, these states do not simply tax it again coming out.
- Pennsylvania generally does not tax retirement distributions received after retirement age.
- New Jersey lets you recover contributions that were already taxed, so only the part of each payment that was never taxed is taxable.
- Massachusetts also allows previously taxed contributions to be recovered, according to secondary sources.
So the state tax is largely a timing cost rather than a permanent one, provided you are still a resident of that state when you take the money. If you move away first, the question becomes whether your old state can tax it at all.
Moving before you retire
A federal law, 4 U.S.C. 114, stops states from taxing the retirement income of people who are not their residents. Retirement income includes payments from a qualified plan such as a cash balance plan, and from an IRA. A state where you lived while you contributed cannot tax the money once you have moved away and are no longer a resident.
This cuts both ways. For someone who deducted contributions in a high-tax state and later moves to a state with no income tax, the deferred state tax is generally never collected. For someone in Pennsylvania, New Jersey or Massachusetts who paid state tax on contributions and then moves, that tax has already been paid and is not refunded.
Where you live when the money comes out usually decides which state, if any, taxes it. If you expect to retire in a different state, that is worth factoring in.
States with no income tax
Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming have no broad-based tax on wages or business income. For owners there, a contribution saves federal tax only, and a later move out of the state brings no state tax on contributions made while living there. Washington taxes certain capital gains, which does not affect retirement contributions.
Every other state is assumed to follow the federal deduction because it starts from federal income. That has not been checked state by state; Alabama, Arkansas and Mississippi, which define income their own way, are the ones most worth confirming. For your own state, see its page under states.