How Does Michigan Tax Retirement Income?

Michigan’s taxation of retirement and pension income has changed significantly over the years, creating rules that can be complex. Tax treatment depends on a retiree’s birth year and the type of income received. The state has recently moved to simplify this structure, but understanding the old rules is still necessary during the current transition period.

Determining Your Tax Treatment by Birth Year

A 2011 law established Michigan’s “three-tier” retirement tax system based on a taxpayer’s birth year. For those filing a joint return, the birth year of the older spouse is used to determine which tier applies. This classification is the starting point for understanding your potential tax liability on retirement benefits.

Taxpayers born before 1946 fall into Tier 1 and receive the most favorable tax treatment. For private and public retirement income, such as from 401(k)s or government pensions, Tier 1 filers can deduct a large amount. For the 2023 tax year, this was capped at $61,518 for single filers and $123,036 for joint filers.

The rules are more restrictive for those in Tier 2, which includes individuals born between 1946 and 1952. Before age 67, their retirement benefits were taxable. At age 67, they could claim a smaller deduction against all income, which was subject to income limitations.

Individuals born after 1952 are classified under Tier 3. For this group, most retirement income was taxable until age 67, at which point they qualified for the most limited deduction.

The 2023 Retirement Tax Law Changes

Michigan’s Public Act 4 of 2023 began a repeal of the three-tier system. The law phases out the old system over a four-year period, beginning with the 2023 tax year. By the 2026 tax year, all retirees will have access to the same substantial deduction, equalizing the treatment for everyone.

The new law introduces a gradually increasing deduction that retirees can choose instead of the old tier-based calculation. For the 2023 tax year, this was an election to deduct up to 25% of the maximum Tier 1 amount. This percentage increases to 50% for 2024, 75% in 2025, and will reach 100% for the 2026 tax year and beyond.

Eligibility for this new deduction option during the phase-in period is restricted by birth year. For 2023, only those born between 1946 and 1958 could make the election. For 2024, eligibility expanded to include those born through 1962, and for 2025, it expands to those born through 1966.

The 2023 law offers taxpayers a choice during the transition. For tax years 2023 through 2025, eligible retirees can calculate their tax liability using either the old three-tier system rules or the new phased-in deduction. They can then choose the method that results in a lower tax bill.

The law also created an immediate benefit for certain public safety retirees. Beginning in 2023, retired public police officers, firefighters, and corrections officers can deduct all of their retirement benefits from Michigan service, regardless of their age.

Types of Retirement Income and Their Taxability

The state’s definition of retirement benefits is broad. It includes distributions from private employer-sponsored plans like 401(k)s, 403(b)s, and traditional pension plans. Withdrawals from Individual Retirement Arrangements (IRAs) are also included.

Pensions from public employment, including those for state and local government workers and most federal civil service pensions, are also factored into the retirement income calculation. The new law allows the deduction to be applied against this income.

Two sources of income have special treatment and are fully exempt from Michigan state tax. First, Social Security benefits are not taxed by Michigan, regardless of your age or income level. Second, retirement pay received for service in the U.S. Armed Forces is fully deductible.

How to Claim Retirement and Pension Deductions

To claim the deduction, you must complete the Michigan Pension Schedule and attach it to your MI-1040 individual income tax return. On the schedule, you will report all pension and retirement benefits, including any that may be fully deductible like military retirement pay.

The schedule will guide you in calculating the deduction under both the old and new systems to determine which is more beneficial. You then transfer the final deduction amount to your MI-1040, which reduces your adjusted gross income for the state.

The Michigan Department of Treasury provides detailed instructions for these forms. It also offers an online estimator to help retirees determine which deduction option is more favorable for their specific financial situation.