During the last session, the General Assembly moved the amount of pension income excluded from income tax from the first $41,110 down to $31,110 as part of the Commonwealth's historic tax reform package. Even with the change, Kentucky still has one of the highest tax exemptions for pension income in the United States, according to an analysis conducted here at Pegasus Institute. Perhaps more importantly though, the exemption doesn't seem to be helping Kentucky retain retirees, which was the original justification of the loophole.
How Kentucky's Exemption Compares
There are wide variations around the country in the treatment of pension income. Nine states (Alaska, Florida, Nevada, New Hampshire , South Dakota, Tennessee, Texas, Washington, and Wyoming) do not have a state income tax and therefore do not tax pension income either. An additional five states (Alabama, Hawaii, Illinois, Mississippi, Pennsylvania) provide for full tax exemptions on pension income, with Alabama having a full exemption on defined benefit pension plans and separate tax laws for other plans.
Two of Kentucky's neighbors are among the 14 states that go in the opposite direction, providing no exemption, treating all income equally (Arizona, California, Connecticut, Idaho, Indiana, Kansas, Massachusetts, Minnesota, Nebraska, North Carolina, North Dakota, Rhode Island, Vermont, West Virginia). Two more states, Ohio and Utah, do not provide for a traditional exemption but do provide a tax credit. The credit in Ohio is up to $200 with an additional $50 credit for those over the age of 65. The credit in Utah is $450 for an individual filer and $900 for a married couple.
The remaining states have a range of exclusion amounts, virtually all of which are significantly lower than Kentucky's, even after the change during the 2018 Legislative Session. New Mexico maintains a relatively low exclusion at $2,500, with four other states below $10,000. Of particular note, many states including Wisconsin, Delaware, Colorado, New York, and South Carolina, have different exclusion amounts depending on age. This is noteworthy for Kentucky which is the only state in the United States where state employees can retire and immediately begin drawing their pension before turning 50, the average age of retirement for teachers is 59, and the state has one of the lowest average overall retirement ages in the country.
Does the Exclusion Even Work?
One of the key questions is whether the exclusion serves its purpose in the first place. The argument for a pension exclusion was that it would allow us to retain more retirees, keeping them in Kentucky rather than moving to other states. In 1994, the year before the exclusion was added, 10.28% of pensioners in the Teacher Retirement System, the system with average incomes more likely to be impacted by the exclusion, lived outside of Kentucky. Last year, 11.39% of pensioners in the Teacher Retirement System lived outside of Kentucky. Not only has the exclusion failed to keep more pensioners in Kentucky, a higher percentage have actually left, even with the exclusion in place. Additionally, our current percentage of pensioners living outside the state (11.39%) is nearly the exact same as Indiana (11.3%), which provides virtually no income tax exemptions for retirees.
There is ample evidence to declare the pension exclusion is a policy failure and a credit which has not achieved its goals. Of equal importance though, evidence suggests that the new threshold, which allows pensioners to take $31,110 in annual income without paying state taxes, will in most cases only impact retirees with above average pension income.
Despite having not been a serious election issue, there is some discussion on reversing the change made by the legislature this year. From a policy standpoint, there is virtually no justification to do so. The change still leaves Kentucky with one of the highest pension exclusions in the United States, does not impact the average retiree, and would only further erode Kentucky's tax base at a time that the legislature has rightly worked to broaden it.