About 300,000 California taxpayers are learning an annoying and costly lesson this year: What's good for Uncle Sam isn't necessarily good for the state.
Since January, these taxpayers have begun receiving letters from the state Franchise Tax Board asking them to pay as much as $275 each in back taxes and interest because they illegally deducted contributions to individual retirement accounts on their 1982 state tax returns.
The taxpayers mistakenly believed that California treats IRAs in the same way that federal tax rules do. Under federal rules, individual taxpayers may deduct IRA contributions up to $2,000 per year regardless of whether the individual already belongs to a "qualified" corporate or Keogh pension plan, profit-sharing or stock-bonus plan, a government employees retirement plan, a tax-deferred annuity or certain other retirement plans.
Much More Restrictive
California law, however, is much more restrictive. The state allows the deduction only if the taxpayer does not have one of these retirement plans. That was also the case under federal rules before 1982.
In addition, even for those who do qualify, California allows an annual IRA deduction of only $1,500, or 15% of the taxpayer's income, whichever is lower.
"A lot of people looked at the federal return, and automatically assumed that the state treated IRAs the same as federal," Franchise Tax Board spokesman Will Bush says.
"I don't think anybody deliberately was trying to do it," he adds.
Most of the 300,000 erring taxpayers did not qualify for the state deduction at all, Bush says. Some did qualify, but wrongly took a deduction greater than $1,500 or 15% of their income, he says.
May Have Made Same Error
Many of these taxpayers may have made the same errors on their 1983 and 1984 state returns as well, he says. They may not have learned of the error in their 1982 returns because half of the 300,000 notices won't be sent until after the April 15 tax deadline for 1984 returns.
The one- to two-year delay in processing returns is due partly to late filings and to the time needed to investigate whether taxpayers already had other qualified retirement plans, Bush says. Work on processing 1983 returns will begin this summer, he says.
About 700,000 state taxpayers took legal IRA deductions in 1982, he added.
The state expects to collect about $30 million from the erring taxpayers. The average bill is about $108, with the maximum at about $275 ($220 back taxes and $55 interest) for a taxpayer erroneously taking the entire $2,000 deduction.
Taxpayers can protest the assessments within 60 days of receiving the notices, Bush says. Otherwise, they will be sent a bill after 80 days, with payment due when received. Those delaying payment will not incur a penalty, but will have to pay additional interest, he adds.
Understandably, many taxpayers are not happy about having to pay up. Many contend that the state tax materials were vague in 1982 in explaining the state rules.
"People are perturbed when they get these letters and find they did something wrong, when they never intended to do something wrong," says Assemblyman Eric Seastrand (R-San Luis Obispo), who is sponsoring a bill to bring state IRA rules into conformity with federal rules.
Seastrand and other proponents of state IRA reform hope that this taxpayer furor, coming at a time when the state is running a healthy budget surplus, may help their efforts. Six bills, three in the Assembly and three in the Senate, are under consideration in the current session.
At least eight previous bills to change the law failed, largely because California was running budget deficits or because it would cost millions in lost tax revenues. The Franchise Tax Board currently estimates that changing state IRA laws to fully conform to national laws would result in a $230-million revenue loss annually.
Such a large potential loss undoubtedly will foster resistance to full IRA reform. But at least one bill, sponsored by Assemblyman Robert W. Naylor (R-San Mateo), is making IRA reform contingent on an unexpectedly high state budget surplus.
It would reform IRA rules if the surplus exceeds $1.6 billion in fiscal 1985-86 beginning this June. The expected surplus for that year is $1.1 billion, according to some estimates, up from about $1 billion at the end of the current fiscal year.
"The climate is much more improved for this type of legislation to pass," says Robin Quiroz, a staff assistant to Naylor.
Meanwhile, the Franchise Tax Board has been stepping up efforts to inform taxpayers about the different state rules. Its 1984 state tax instruction book does a better job of explaining the rules, says Bush. In addition, he says, the agency has been spreading its message through press releases and a newsletter sent to 28,000 tax preparers.