Cost of Illinois' Retirement Income Tax Exemption

March 17, 2014

Unlike the federal government, the State of Illinois exempts all retirement income from the individual income tax. Of the 41 states that impose an income tax, Illinois is one of only three that exempt all pension income and one of 27 that exclude all federally taxed Social Security income, according to a report from the Chicago Metropolitan Agency for Planning.

The Illinois Comptroller estimates that this exemption of federally taxable retirement income reduced the State’s individual income tax revenues by $2.0 billion in FY2012. The cost of this exemption is expected to increase over time due to a population shift in Illinois. According to data available on the website of the Department of Commerce and Economic Opportunity, the number of senior citizens in Illinois is expected to grow considerably from 1.7 million in 2010 to 2.7 million by 2030.

The Comptroller’s estimate of the State’s revenue losses due to the exemption is based only on federally taxable retirement income. The federal government provides some relief for lower income retirees by exempting Social Security benefits below a certain threshold. Individual senior citizens do not have to pay federal income taxes on their Social Security benefits if the sum of half of their Social Security benefits combined with all other income is less than $25,000 annually. For couples the threshold is $34,000.

As part of a comprehensive plan to stabilize the State of Illinois’ finances, the Civic Federation recently proposed eliminating the exemption for federally taxable retirement income. In its FY2015 Budget Roadmap, the Federation recommended that the State broaden the income tax base to include federally taxable retirement earnings to create greater equity among taxpayers and facilitate the gradual rollback of the income tax rates for all. The report also found that the broader base would also ensure greater long-term sustainability of the State’s resources by accessing a growing portion of the economy.

The FY2015 Budget Roadmap illustrated the effect of expanding the income tax base to include federally taxed retirement income by providing estimates for income tax revenues that could be generated from eliminating the exemption starting on January 1, 2015. The revenue projections were based on the Comptroller’s data for FY2012. The amount of revenue generated by eliminating the exemption was then increased at a rate of 6.5% annually based on data available from the Internal Revenue Service for 1999 through 2011.

The Civic Federation’s comprehensive solution to the State’s ongoing financial crisis is based on the additional revenue from expanding the income tax base to include retirement income combined with limiting agency spending and eliminating new diversions from the State income tax revenues. The Federation's plan also called for extending the increased income tax rates passed in 2011 for one year, rather than allowing for the steep roll back in FY2015 under current law. The State would then be able to eliminate its $5.4 billion backlog of unpaid bills, establish a rainy day fund and gradually roll back the income tax rates to 4.0% from 5.0% for individuals (including retirees) and to 5.6% from 7.0% for corporations. The plan also provided additional funding for local governments and showed the budgetary savings expected from the new State pension law passed in December 2013 beginning in FY2016.  

The following table from page 37 of the report, shows the five-year impact of taxing retirement income in Illinois combined with the Civic Federation’s other recommendations for stabilizing the State’s finances.

By adding a growing portion of the economy to the tax base, the State would ensure a more sustainable revenue source over time and allow for the gradual rollback of income tax rates. The individual income tax base is expected to grow at a rate of only 1.9% compared to the retirement income growth rate of 6.5%.

Although the projections in the table above show the revenue generated from all federally taxable retirement income in Illinois, the Civic Federation also presented findings that additional exemptions for low income seniors could be included without undermining the overall effectiveness of the recommendation.

Based on data for 2011 from the Internal Revenue Service, federally taxed disbursements from individual retirement arrangements, pension income and Social Security income for all taxpayers earning below $50,000 annually made up less than 25% of the retirement income tax base, which totaled $43.8 billion of untaxed retirement income. Furthermore, only $1.6 billion, or 2.6% of total Social Security income, was earned by households with a total adjusted gross income under $50,000 annually.

The following table shows retirement income by source and income level in Illinois in 2011, the most recent year for which data are available.

Based on the historical 6.5% growth rate in retirement income, those earning less than $50,000 per year in retirement income could be exempted from Illinois’ income tax while still effectively buttressing the State’s revenue base. This would also allow the State to craft an exemption that would keep the tax environment for retirees competitive with surrounding states.

All of the states regionally connected to Illinois tax some portion of retirement income, as described below:

Wisconsin exempts Social Security income and has a graduated income tax (4.4%-7.65%) with a high exemption for its lowest bracket totaling $10,750 for individuals and $14,330 for couples. Wisconsin also has multiple tax credits for low-income seniors earning under $10,000 annually.

Indiana exempts only Social Security income and has a flat income tax rate of 3.4%.

Iowa taxes all retirement income over $6,000 for individuals and $12,000 for couples but is phasing out the taxation of Social Security income after 2014. Its graduated income tax ranges from 0.36% on income less than $1,494 to 8.98% on amounts above $67,230. There is considerable progressivity on the low end of the income tax scale, which jumps to 4.5% from 2.43% at $5,976 and then to 6.12% above $13,446.

Michigan has a complicated tax based on age that mostly exempts Social Security, military pensions and railroad pensions. The state also allows for exemption of $20,000 of retirement income for single filers and $40,000 for joint filers. The deduction for retirement income other than Social Security is being phased out for those born after 1946. The state has a flat income tax rate of 4.25%.

Missouri exempted Social Security income starting in 2012. For all other retirement income the graduated income tax rates apply, which start at 1.5% for amounts under $1,000, increasing at 0.5 percentage points for each additional $1,000 of income up to the highest rates of 6.0% for amounts over $9,000.

Kentucky exempts all Social Security income but taxes other retirement income above $41,110 annually. The state has a graduated income tax ranging from 3.0% for those earning under $3,000 annually and 6.0% for those earning more than $75,000 per year.