BILL #    SB 1371	TITLE: income tax; subtraction; retirement distribution
SPONSOR:    Mesnard	STATUS: As Amended by Senate FIN
PREPARED BY:    Benjamin Newcomb

Description

SB 1371, as amended by the Senate Finance Committee, would subtract: (1) distributions from pension and retirement accounts for taxpayers aged 67 and older and (2) nondeductible contributions to individual retirement accounts (IRA), excluding Roth IRAs, from the calculation of Arizona gross income (AGI). The total value of both subtractions combined is limited to the same amount as the standard deduction each year.

The income subtraction would apply to public and private pensions as well as distributions from qualified retirement plans and IRAs. Under the amended version of the bill, contributions to Roth IRAs would not be exempt from state income tax, while a taxpayer would be able to deduct contributions to other IRAs not deductible at the federal level.  The taxpayer could take the IRA deduction in addition to the standard deduction.  The bill would become effective retroactively from Tax Year (TY) 2025, affecting FY 2026 collections.

Estimated Impact

We estimate the bill would reduce General Fund revenue by $(386.7) million annually starting in FY 2026. See Table 1 in the Analysis section below. Our estimate does not reflect the bill's potential dynamic effects, which are typically secondary to the direct impact. For example, all else being equal, exempting a large portion of retirement distributions from IIT may serve as an incentive for more retirees to move to the state, which would increase consumer spending that may result in greater economic output. If implementation of this bill would require lower state spending, taxpayers may lower their consumption, which may result in lower economic output.

Given the lower level of liability under the bill, taxpayers may qualify for a lower level of nonrefundable IIT credits.

We have asked the Department of Revenue (DOR) for their estimate of the bill's impact but have not yet received a response.

Analysis

Distributions from Pensions and Retirement Accounts

According to the most recent data from the Internal Revenue Service (IRS), taxable retirement distributions in Arizona were $30.33 billion in TY 2022. Based on the 5-year average annual growth in retirement distributions, which is 4.6%, we estimate this total will grow to $34.70 billion by TY 2025.

The Office of Economic Opportunity (OEO) produces low, medium, and high projections of Arizona's population by year through 2060 and includes estimates by age group. Based on the medium series, we estimate that of those aged 59.5 and older (the minimum eligible age to begin receiving distributions), 66.0% are at least 67 years old. Applying this percentage to the overall level of retirement distributions, we estimate that $22.89 billion of distributions would be eligible for the subtraction under the bill.

Filers cannot subtract more than the standard deduction amounts each year. In TY 2025, these are $15,000 for single filers, $22,500 for unmarried heads of household, and $30,000 for those married filing jointly. Using the most recent data from DOR on the distributions of filers and taxable income by filing status and applying them to our distribution estimate, we project that of the $22.89 billion of subtraction-eligible distributions, only $14.70 billion would be subtracted from AGI. Since the state's IIT rate is 2.5%, there would be a $(367.6) million annual decrease in income tax collections beginning in FY 2026. Of this amount, $(237.2) million would be from pension distributions and $(130.4) million would be from IRAs. See Table 1 below.

Nondeductible Contributions to Individual Retirement Accounts (IRA)

Under the Internal Revenue Code, contributions to a Roth IRA cannot be deducted from Federal Adjusted Gross Income (FAGI) and is therefore subject to federal income tax. Some or all the contributions to other IRAs may be nondeductible under federal law depending on whether the taxpayer is covered by a retirement plan at work and if their income exceeds a certain threshold. Under SB 1371, however, nondeductible contributions to any non-Roth IRA will be deductible for state income tax purposes. Contributions to Roth IRAs would remain nondeductible.

Based on the latest IRS data, which is from TY 2020, we estimate that the total amount of nondeductible, non-Roth IRA contributions in the U.S. was $26.50 billion that year. Since Arizona makes up about 2.2% of the U.S. population, we estimate approximately $582.9 million of subtraction-eligible contributions were made by Arizonans. Growing this total to 2025 based on the 5.6% 5-year average annual growth rate of these IRA contributions, we estimate that this amount would be $763.7 million in TY 2025. Since the non-Roth IRA contributions can be taken in addition to the standard deduction, we assume that all the contributions would be deducted from AGI.  At a 2.5% tax rate, $763.7 million in non-IRA contribution deductions would reduce General Fund revenues each year by $(19.1) million in FY 2026. See Table 1 below.

Combining the impact of subtracting retirement income for those aged 67 or older and retirement contributions to nondeductible IRAs (other than Roth IRAs) from AGI, we estimate annual IIT revenue will decrease by $(386.7) million beginning in FY 2026.

Table 1
FY 2026 Impact of SB 1371 As Amended
$ in millions
	Income Subtracted ^1^/	General Fund Impact
Pension Distributions	$9,487.6	$(237.2)
IRA Distributions	5,216.6	(130.4)
Nondeductible Non-Roth IRA Contributions	763.7	(19.1)
Total	$15,467.9	$(386.7)
____________
1/   This is the amount subtracted after accounting for the standard deduction limits

Local Government Impact

Incorporated cities and towns receive 18% of individual and corporate income tax collections from 2 years prior from the Urban Revenue Sharing (URS) Fund established by A.R.S. § 43-206. Since the bill would decrease statewide IIT revenue by $(386.7) million in FY 2026, overall URS distributions to cities and towns would decrease by $(69.6) million in FY 2028.

2/20/25