Does Michigan Tax Pensions Under the New Law?

Michigan’s approach to taxing retirement and pension income has undergone changes, creating new options for retirees. The state has moved from a complex, age-based system to a more uniform deduction that will be phased in over several years. Understanding these regulations is important, as the choice between the old and new systems can directly impact a retiree’s annual tax liability.

The Three-Tier System for Pension Taxation

Michigan’s taxation of retirement income was long dictated by a three-tier system based on a taxpayer’s birth year, which remains an option for retirees. For those filing a joint return, the birth year of the older spouse determines the tier.

The first tier includes taxpayers born before 1946. These individuals receive the most favorable tax treatment, continuing under the rules that existed before 2012. Under this tier, all retirement benefits from public sources, such as federal civil service and state government pensions, are fully deductible. Private retirement income, including distributions from 401(k)s and IRAs, is also deductible up to inflation-adjusted limits; for 2023, these were $61,518 for single filers and $123,036 for joint filers.

The second tier applies to retirees born between 1946 and 1952. These taxpayers are eligible for a limited deduction against all types of income. Once they reach age 67, they can deduct up to $20,000 for single filers or $40,000 for those married filing jointly.

The third tier covers taxpayers born after 1952. Under this system, their retirement and pension income was subject to Michigan income tax with no special state-level deduction until they reached age 67. After turning 67, they could choose between taking a standard deduction or forgoing that to continue exempting any Social Security income.

The 2023 Retirement Tax Law Changes

Michigan enacted Public Act 4 of 2023, which introduced a gradual phase-out of the tax on most retirement income. This law creates a new, alternative deduction method. The changes are designed to restore the broader pre-2012 exemptions and provide financial relief to seniors.

The new law establishes a four-year phase-in period where eligibility is restricted by birth year. The deduction percentage and the eligible group of taxpayers expand each year:

• For the 2023 tax year, taxpayers born between 1946 and 1958 could deduct 25% of the maximum retirement income limits.
• For the 2024 tax year, the deduction increases to 50% and is available to those born between 1946 and 1962.
• For the 2025 tax year, the deduction rises to 75% for taxpayers born between 1946 and 1966.
• Beginning in 2026, the deduction reaches 100% and will be available to all taxpayers, regardless of birth year.

This new, uniform deduction applies to both public and private pension benefits. However, distributions from deferred compensation plans, such as 457 plans, do not qualify for this deduction. The law also includes a provision for retired public police or fire department employees, Michigan State Police, and county corrections officers, who can elect to deduct their retirement benefits without any cap.

Choosing Your Best Tax Option

Retirees must choose between using the deduction available under the old three-tier system or opting for the new, phased-in deduction. This decision should be made annually to ensure the most financially advantageous outcome, as individual circumstances may change. The choice directly impacts the amount of retirement income subject to state tax.

Retirees in Tier 1 (born before 1946) will almost certainly benefit by continuing with the old rules, which allow them to deduct all public pension income and a large portion of private retirement income. Conversely, those in Tier 3 (born after 1952) will likely find the new phase-in deduction more beneficial, as the old system offered them little to no deduction on their retirement income.

The decision is more complex for Tier 2 filers (born 1946-1952), who must perform a direct comparison. For example, a married couple filing jointly in this tier is limited to a $40,000 standard deduction under the old rules. For the 2025 tax year, the new deduction rises to 75% of the maximum limit. Based on the 2023 maximum of $123,036 for joint filers, this would equal a deduction of over $92,000, making it far more advantageous than the $40,000 option. By 2026, the deduction will reach 100%.

Claiming the Deduction on Your Tax Return

Once you have determined the most beneficial deduction, you claim it on your Michigan income tax return. The primary forms involved are the MI-1040 and Schedule 1, which includes the Michigan Pension Schedule. The state has incorporated all available retirement subtraction options into its tax forms.

To claim the deduction, you will report your total retirement and pension income and then subtract the allowable amount on Schedule 1 of the MI-1040. Tax software and the instructions for the MI-1040 guide filers through the necessary calculations, whether you are using the tier-based system or the new phase-in deduction.

For those with specific types of income, such as military retirement or railroad retirement benefits, these are reported on a designated line of Schedule 1 and remain fully exempt. It is important to complete the relevant worksheets and schedules accurately to ensure you receive the maximum deduction. The Michigan Department of Treasury provides estimators and detailed instructions on its website to assist.