AskNC: Why does North Carolina tax the pensions of some military retirees?

By Jmturner (Own work) [Public domain], via Wikimedia Commons

When thinking about where to retire, people consider many factors, including distance to family and climate. For many, the decision is also an economic one. Because most retirees live on a fixed income, they want to know where they will be getting the most bang for their buck.

Our readers want to know why North Carolina taxes the pensions of some military retirees while many other states do not. We received three questions about this issue:

• One reader asked: “Why does NC tax the pensions of some military retirees?”
• Reader Robin Grinstaff asked: “Why does NC tax military retirees pay checks?”
• A third reader asked: “Why does NC tax the pensions of military retirees? When states like Alabama, Hawaii and New York (just to name a few) do not?”

As is the answer to many questions, it is complicated. It all started in Michigan.

Davis v. Michigan Department of Treasury

For years, North Carolina was one of several states that exempted retirement benefits for state and local employees, including teachers, from taxation. However, military and federal government retirees had to pay state income tax on their retirement benefits.

In 1984, a former United States federal government employee, Paul S. Davis, sued the Michigan Department of Treasury, arguing that the taxation of his federal retirement benefits was discriminatory. The case made its way to the United States Supreme Court in 1989, and in Davis v. Michigan Department of Treasury, the Supreme Court declared that federal and military retirees could not be taxed differently than state retirees.

For North Carolina, this meant they either had to exempt federal and military retirement benefits from taxation, or they had to remove the exemption for state and local government employees and tax their retirement benefits. On August 12, 1989, the General Assembly passed legislation repealing the tax exemption for state and local employees and taxing all federal, state, local and military retirement benefits above $4,000.

Bailey v. State of North Carolina

Naturally, retirees who were used to not paying taxes on their retirement benefits as well as current government employees who had been promised tax exemption did not think it was fair for the state to suddenly start taxing their benefits. In 1990, Judge Bailey along with several retired state and local government employees filed a suit arguing that the removal of the tax exemption was unconstitutional because it would “deprive them of benefits to which they had a vested right.” The 1990 suit (Bailey I) was dismissed on technical grounds, but the group filed a follow-up suit in 1992, which ended up in the North Carolina Supreme Court.

In 1998, the North Carolina Supreme Court ruled in Bailey v. State of North Carolina that North Carolina could not tax retirement benefits for federal, state, and local government employees, including military, who were vested in the retirement system as of August 12, 1989. In this case, vested in the retirement system meant employees had five years of service prior to August 12, 1989. Furthermore, the Supreme Court ruled that any state or local government retiree could recover the income taxes they had paid on their retirement benefits since 1989.

Before a trial court could determine who was qualified for a refund of their income taxes, the state and the plaintiffs settled the lawsuit. The settlement required North Carolina to refund federal, state, and local government retirees who were vested in the retirement system and paid income tax on their retirement benefits from 1989 to 1998. It also stated that these individuals would not pay income tax on their retirement benefits in the future.

As a result, federal, state, and local government employees, including military, who had five years of service prior to 1989 do not have to pay income taxes on their retirement benefits. However, employees who are not vested, or did not have five years of service before 1989, are required to pay taxes on their retirement benefits above $4,000.

Moving forward

Since the Bailey settlement, advocates have been pushing for legislation exempting all government and military retirement benefits from taxation. There are currently two bills in the legislature on this issue.

House Bill 103 would exempt all civil servant pensions (including military) from taxation. It is currently sitting in the House Finance Committee. Senate Bill 153 provides income tax exemption for active service members and military retirees. It passed the Senate in June 2017 with 47 votes (3 abstaining), and it is also now sitting in the House Finance Committee.

Supporters of these bills argue it is unfair that some retirees get tax exemption simply because they started working earlier. The main advocacy group is an organization called The 4th Branch, which describes itself as “a coalition of groups representing the interests of military, federal, state and local public-service retirees and current employees in those fields.”

Robert Allen, federal co-chair of The 4th Branch, is a retired federal civil servant with three years of military service. Despite the fact that he qualifies for the Bailey settlement so his pension is not taxed, he joined The 4th Branch to fight to get tax exemption for all military and civil servants. According to Allen, the goal of The 4th Branch is “to be able to get the legislature to pass a law where all civil servants and military retirees are exempted from paying taxes on their pensions.” 

Any decision to extend the tax exemption to all military and government retirees must also account for the cost of doing so.

The 4th Branch argues not only is it more fair to extend the tax exemption to all military and civil servants, but it would also provide an economic benefit to the state by creating jobs and stimulating growth. According to Doug Dickerson of AARP, military retirees are highly sought after employees. “Military retirees tend to be almost ideal employees for companies that are looking for talent [in terms of] work ethic, training, responsibility, and leadership.” One way to attract companies to North Carolina, he said, is to attract this type of talent via favorable tax laws.

However, a proposal to remove taxes will cost the state in the form of lost revenue. Fiscal Research estimates the annual cost of exempting only military retiree pensions from taxation to be $22.7 million in 2017-2018, growing to $32.2 million in 2021-22. The cost of exempting all civil servants’ retirement benefits would be much higher than these estimates, which is one reason the future of the bills in the legislature is uncertain. Both bills are competing for funding with numerous other programs and services, and it remains to be seen whether they will even  make it out of the House Finance Committee for a full vote.