Massachusetts 403(b) Tax Trap: How to Avoid Double State Tax on Pre-1998 Contributions
By Tim Hayes, Financial Advisor for the Public and Not-for-Profit Sector
Why Finding Pre-1998 Contributions Is Critical
For an individual retiree with a long career, their pre-1998 basis could be $30,000 to $80,000 or more — protecting $1,500 to $4,000+ of retirement income from being taxed twice.
The 1998 Law Change: The Source of the Problem
Before 1998, the retirement law in the Commonwealth of Massachusetts allowed taxpayers to deduct their 401k plan contributions from federal and state income taxes. However, only federal tax deductions were allowed for a 403b plan (tax-sheltered annuity), not state tax deductions.
In 1998, Massachusetts changed the law to allow 403b participants to deduct their contributions from federal and state taxes. Participants were then required to keep records of their pre-1998 403b contribution amounts to avoid paying taxes on these contributions twice when they started receiving distributions after retirement.
How Overlooking the Law Leads to Double Tax
Regrettably, many individuals have overlooked the 1998 law change, leading to situations where they have withdrawn from their 403b plans without considering the pre-1998 contributions. This oversight could result in them paying state tax on these withdrawals a second time.
In addition, many individuals have transferred their 403 (b) retirement plans to an IRA or another 403 (b) company, and it’s unlikely that the new IRA or 403 (b) custodian has been provided with the necessary information regarding the amount already taxed by the state. This lack of proper record-keeping could lead to difficulties for participants.
Fortunately, with proper tax planning and record-discovery, they can avoid the situations described above and potentially save a significant amount of money. If you have pre-1998 403b contributions, check with the provider where you contributed to see if they have that number.
The Scale of the Problem: A Billion-Dollar Oversight
This isn't a minor accounting error. It's a widespread, systemic issue affecting a generation of Massachusetts retirees. While no official total exists, we can understand the scale with a reasonable, conservative estimate.
Here is how we arrive at the numbers:
- Population: In the 1990s, Massachusetts had roughly 500,000 employees in 501(c)(3) sectors eligible for 403(b) plans (public/private education, healthcare, non-profits).
- Participation: Pre-1998, plan participation was lower. We assume a 25% participation rate, yielding 125,000 participants.
- Average Contribution: Using period-average salaries (~$35,000) and a conservative contribution rate (3.5%), the average annual contribution was ~$1,225.
- Time: We assume an average of 7 years of pre-1998 contributions per participant.
The Conservative Estimate
125,000 participants × $1,225/year × 7 years = ~$1.07 Billion in total pre-1998 contributions.
The Potential Tax Impact
$1.07 Billion (at-risk principal) × 5% (MA state tax rate) = Over $53 Million in potential double-taxation.
What This Means For You:
For an individual retiree with a long career, their pre-1998 basis could be $30,000 to $80,000 or more. Correcting this oversight isn't about a small refund; it's about protecting $1,500 to $4,000+ of your retirement income from being taxed twice.
You are not alone in this. The math confirms it's a widespread, costly oversight.
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The Solution: It's Not Too Late to Recover
The silver lining is that even if individuals have made withdrawals from a 403b or IRA rollover without considering the pre-1998 contributions, the state does not require them to account for these contributions the first time they were eligible to do so. They can still do it today by adjusting their future state income tax returns for the pre-1998 amounts, offering a hopeful path to potential tax savings.
My Process: How I Help Find Lost Contribution Records
Tracking down pre-1998 contribution records is genuinely difficult. The two most reliable sources are your current 403(b) provider — who likely has the records if you’ve stayed with them — and your school district’s payroll office, which often has the records but may require persistent follow-up to retrieve them. I’ve worked through both avenues with clients, with varying results. If the records exist, we’ll find them. If they don’t, I’ll be straightforward with you about what’s recoverable and what isn’t.
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These are the opinions of Financial Advisor Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only and should not be construed or acted upon as individualized investment advice. Content provided via links to third-party sites should not be considered an endorsement of content that we cannot verify completeness or accuracy of.