After the Bailey court order on 401(k) and 457 plan vesting, does the August 12, 1989 date still control class membership, or did the court drop that requirement?

Plain-English summary

In Bailey v. State (1998), the NC Supreme Court held that NC state and local government employees who had "vested" in the state's retirement systems by August 12, 1989, had a contractual right to receive their retirement benefits free of state income tax. The decision was triggered by legislation passed on August 12, 1989, that subjected those retirement benefits to state income tax for the first time. The Court found that the change unconstitutionally impaired the contractual rights of employees who had already vested.

The state and the plaintiffs negotiated a settlement (consolidating Bailey with related federal-retiree litigation called Emory and Patton). The settlement covered employees in the principal state and federal retirement plans, plus participants in the state's Supplemental Retirement Income Plan (a 401(k)) and Deferred Compensation Plan (a 457). For the 401(k) and 457 plans, the "vesting" date and the rule for figuring out when a participant became "vested" needed special treatment, because those plans don't have a five-year service vesting period the way pension plans do.

The court entered a class-definition order in November 1998 with a wrinkle: Finding of Fact No. 3 said 401(k) and 457 participants "vest" upon first making contributions if vesting took place by August 12, 1989. But Conclusion of Law No. 3 said only that participants "vest" upon first making contributions, without repeating the August 12, 1989 date.

Jack Pruitt, the Retirement Systems Director, was worried this might mean ANY 401(k) or 457 participant who ever contributed (even years later) would qualify as a Bailey class member. He asked the AG.

The AG answered that the August 12, 1989, date still controls.

Reasoning:

• The constitutional core of Bailey is benefits vesting before the taxation legislation passed on August 12, 1989. That is the moment the contractual rights crystallized. Vesting after that date cannot give rise to a Bailey claim because the right would have vested into a regime that already subjected the benefits to state income tax.
• The Bailey opinion itself says "Class plaintiffs are North Carolina state and local government employees whose retirement benefits vested on or before 12 August 1989, the ratification date of the Act." (348 N.C. at 139, 500 S.E.2d at 59.) And: benefits of all employees "whose retirement rights became vested prior to 12 August 1989 must be exempt from state tax." (348 N.C. at 142, 500 S.E.2d at 61.)
• The Consent Order that frames the settlement preserves the August 12, 1989, date. The only thing the parties left for later resolution was the method of "vesting" for 401(k) and 457 plans (which works differently from defined-benefit pensions). The DATE was never up for negotiation.
• Conclusion of Law No. 3, read in context with Finding of Fact No. 3 and with the Bailey opinion itself, addresses how to figure out when a 401(k) or 457 participant becomes vested (answer: upon first contribution to the plan), not when. The "when" was always going to be August 12, 1989, because that is the constitutionally relevant date.

So: 401(k) and 457 plan participants are Bailey class members (and entitled to state-income-tax-free benefits) if they made their first contribution to the plan on or before August 12, 1989, and not otherwise.

Currency note

This opinion was issued in 1998. Subsequent statutory amendments, court decisions, or later AG opinions may have changed the analysis. Treat this page as historical context, not current legal advice. Verify current law before relying on any specific rule, deadline, or remedy mentioned here. The Bailey settlement has long been administered and the class is closed; nobody can newly join the class today. The state-income-tax-exempt treatment of Bailey-class retirement benefits has continued, but the operational details of identifying class members, calculating the exempt portion of distributions, and reporting to the Department of Revenue have evolved over time. Retirees who think they may qualify should consult a tax advisor familiar with NC's Bailey settlement administration.

Background and statutory framework

The Bailey case (and the parallel Emory and Patton federal-retiree cases) had significant fiscal stakes for NC. The state had been collecting income tax on retirement benefits paid to thousands of retirees in the years between the August 1989 legislation and the 1998 decision. Bailey effectively required the state to refund those taxes for class members and to exempt future distributions from state tax for class members.

The Simpson v. Local Governmental Employees' Retirement System (1987) decision was a key precedent for Bailey. Simpson established that retirement-system members have a contractual right to rely on the terms of the retirement plan as those terms existed at the moment of vesting. Bailey extended that principle: the August 12, 1989, vesting date was the contractual moment for the no-state-tax-on-retirement-benefits term that had been part of the system at that time.

For most NC state and local retirement systems, vesting means five years of creditable service. For 401(k) and 457 plans, which are voluntary contribution plans rather than entitlement systems, "vesting" had to be defined differently. The Bailey settlement parties agreed that the equivalent for 401(k) and 457 was the first contribution to the plan: by making a first contribution, the participant becomes a "member" with rights to plan benefits on plan terms. That is the closest analog to defined-benefit vesting.

The August 12, 1989, date is the constitutional anchor across all systems. It is the date when the legislation subjecting retirement benefits to state income tax was ratified. Pre-ratification contractual rights are protected. Post-ratification accruals are not.

Common questions

What about employees who contributed to a 401(k) or 457 after August 12, 1989, but who also contributed to a regular state retirement plan and vested in that plan before August 12, 1989?

Those employees are class members based on their defined-benefit plan vesting. The Bailey settlement covers all their retirement benefits, including the 401(k) and 457 distributions. The first-contribution-by-August-12-1989 rule is the specific gateway for 401(k) and 457 participants who were not also in a vested defined-benefit plan.

Are spousal beneficiaries covered?

Generally yes, when the beneficiary inherits the retiree's benefits. The Bailey class includes the contractual right to receive benefits exempt from state income tax. That right runs with the benefit, not just with the original employee. But the specific application to inherited benefits depends on the form of distribution and beneficiary status, and should be reviewed with a tax advisor.

Can the state today change the tax treatment of Bailey class members' benefits?

Generally no. The Bailey rights are contractual and protected by the federal and NC contract clauses against impairment. The state can change tax rules going forward for new employees and for new accruals by non-Bailey class members, but it cannot strip away the contractual right of Bailey class members.

Is there a way to "buy in" to Bailey class membership through purchasing omitted service credit?

The AG addressed a related question in a separate 2000 opinion on Chapel Hill public safety officers who tried to purchase omitted service to qualify for Bailey class membership. The answer there was that purchasing service today does not retroactively create vested service on August 12, 1989. Class membership depends on what was actually vested on that date, not what could have been purchased.

Source

• Landing page: https://ncdoj.gov/opinions/qualification-for-class-membership-in-bailey-emory-patton-lawsuits/

Citations

• Bailey v. State, 348 N.C. 130, 500 S.E.2d 54 (1998)
• Simpson v. Local Governmental Employees' Retirement System, 88 N.C. App. 218, 363 S.E.2d 90 (1987), aff'd per curiam, 323 N.C. 362, 372 S.E.2d 559 (1988)
• Great Am. Ins. Co. v. Johnson, 257 N.C. 367, 126 S.E.2d 92 (1962)
• N.C.G.S. § 128-21 et seq. (Local Governmental Employees' Retirement System)
• N.C.G.S. § 128-26(m) (purchase of omitted membership service)
• Former N.C.G.S. § 143-166 (Law Enforcement Officers' Retirement System)
• N.C.G.S. § 143-166.50 (transfer of LEOs to Local System)

Original opinion text

November 25, 1998

Jack Pruitt, Director
Retirement Systems Division
Department of State Treasurer
325 North Salisbury Street
Raleigh, North Carolina 27603-1385

Re: Advisory Opinion; Qualification for Class Membership in Bailey/Emory/Patton lawsuits for participants in 401(k) and 457 plans

Dear Mr. Pruitt:

This letter responds to your request for an opinion concerning Class Membership in the Bailey/Emory/Patton lawsuits for participants in the State's Supplemental Retirement Income Plan (401(k)) and Deferred Compensation Plan (457). In particular, your concern derives from language in the Findings of Fact, Conclusions of Law and Order Regarding Class Definition signed by Judge Thompson and entered on November 20, 1998. Specifically, that Order provides in Finding of Fact No. 3 that "[p]articipants in the Supplemental Retirement Income Plan 401(k) and the Deferred Compensation Plan are deemed to 'vest' in those plans upon first making contributions to the plan if said 'vesting' took place by August 12, 1989." Order, ¶ 3 p. 3. Conclusion of Law No. 3, however, does not refer to the August 12, 1989, date. Instead, it provides that "[p]articipants in the Supplemental Retirement Income Plan 401(k) and the Deferred Compensation Plan are deemed to 'vest' in those plans upon first making contributions to the plan." Order, ¶ 3 p. 7. Your concern centered around the lack of any reference to August 12, 1989, in the relevant Conclusion of Law.

The lack of any reference to August 12, 1989, in Conclusion of Law No. 3 does not affect the necessity for 401(k) and Deferred Compensation participants to have contributed by August 12, 1989, in order to be Class Members. Fundamentally, the issue before the Court resolved by this Order was how to determine when participants in those plans vest, not the relevant date for vesting. The North Carolina Supreme Court's decision in Bailey, et al. v. State, 348 N.C. 130, 500 S.E.2d 54 (1998), addressed the plaintiffs' claims that state and local government retirees or future retirees who had "vested" in the respective retirement plans as of August 12, 1989, the date of legislation making those plans' benefits subject to state income taxes, had vested contractual rights to receive their retirement benefits free of state income taxes. In Bailey, the Supreme Court stated that "[c]lass plaintiffs are North Carolina state and local government employees whose retirement benefits vested on or before 12 August 1989, the ratification date of the Act." Bailey, 348 N.C. at 139, 500 S.E.2d at 59. The Court, after discussing the issue further, concluded that

it follows that the retirement benefits of all employees whose retirement rights became vested prior to 12 August 1989 must be exempt from state tax without regard to whether those benefits are attributable to service prior to or after that date.

Bailey, 348 N.C. at 142, 500 S.E.2d at 61. Plainly, the foundation for the Bailey/Emory/Patton settlement and payments is the Supreme Court's Bailey decision, which itself makes Class Membership dependent on "vesting" by August 12, 1989.

Subsequent to the Supreme Court's decision in Bailey, a Consent Order reflecting a settlement of Bailey and federal-retiree litigation was entered on June 10, 1998. That Consent Order provides that persons receiving the benefit of the settlement are federal and state retirees or retirement system members who had five years of service, the "vesting" period for the principal state plans, by August 12, 1989, with one exception. The exception is for 401(k) and Deferred Compensation plan participants and for federal retirees in comparable plans. As to those plans, the parties specified that they reserve the right to continue to seek agreement, or in the alternative submit to the Court for its determination, the issue of "vesting" periods for purposes of tax liability on withdrawals from Deferred Compensation and 401-K Plans by federal and North Carolina state and local government retirees.

Consent Order, ¶ 6 p. 6. Nothing in that Consent Order suggested any deviation from the August 12, 1989, date as the critical factor in determining whether a person would or would not be a Class Member. The issue reserved for later resolution related to how one "vests," not the critical date for vesting, in order to be a Class Member. (The Consent Order has since been put into effect by virtue of legislation enacted by the General Assembly and signed into law by the Governor on September 30, 1998, and by the Superior Court's entry of its Order Approving Class Action Settlement on October 9, 1998.)