Can the Virginia Department of Taxation use a pro-rata formula (instead of cost-recovery) to figure out how much of a retiree's pension distribution is tax-free in Virginia?

Plain-English summary

Senator Creigh Deeds asked the AG a technical tax question that affects retirees who paid into a retirement plan while working in one state but receive distributions while residing in Virginia. Virginia's individual income tax allows a subtraction from federal adjusted gross income for retirement plan distributions where the underlying contributions were already taxed in another state (§ 58.1-322.02(11)). The wrinkle: the contributions get subtracted, but the earnings on those contributions do not. So when a distribution arrives in retirement, how do you figure out which dollars are pre-tax contributions and which are post-tax earnings?

There are two main ways:

1. Cost-recovery rule (Pennsylvania's approach): the entire early distribution is treated as recovery of contributions until the contributions are fully recovered. Then later distributions are taxable as earnings. This is taxpayer-friendly because it pushes tax later.
2. Pro-rata rule (the IRS approach in IRC § 72 for annuities): each distribution is treated as part contributions, part earnings, based on the ratio of contributions to expected total payout. This means some tax is owed on every distribution.

The Virginia Department of Taxation, in Public Document 10-214 (Sept. 15, 2010), adopted the pro-rata rule, reasoning that "a pro-rata approach more accurately reflects the nature of a distribution from a retirement plan." The taxpayer in that ruling had argued for the cost-recovery method.

Senator Deeds asked whether the Department actually has authority to use the pro-rata method. AG Mark Herring's answer: yes. Section 58.1-322.02(11) doesn't specify any methodology. Section 58.1-202(1) gives the Tax Commissioner general supervisory authority over Virginia tax laws. Under Nielsen Co. v. County Board of Arlington (2015), where the statute is silent, the implementing agency has discretion to choose a reasonable method. The Department's choice of pro-rata is a reasonable exercise of that discretion.

The opinion noted that Oregon (Or. Rev. Stat. § 316.159(5)(a)) takes a different approach, treating distributions as initially representing recovery of contributions, while New Jersey (N.J. Stat. Ann. § 54A:6-10(a)) uses a ratio-based approach similar to IRC § 72. The choice among these approaches is up to the General Assembly if it wants to set it by statute; otherwise, the Department of Taxation gets to pick.

Currency note

This opinion was issued in 2020. 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.

Background and statutory framework

Section 58.1-322 sets out the framework for computing Virginia taxable income, starting from federal adjusted gross income. Section 58.1-322.02 lists the subtractions that flow from federal AGI to Virginia taxable income. Subsection (11) is the multi-state retirement plan subtraction:

Any income received during the taxable year derived from a qualified pension, profit-sharing, or stock bonus plan as described by § 401 of the Internal Revenue Code, an individual retirement account or annuity established under § 408 of the Internal Revenue Code, a deferred compensation plan as defined by § 457 of the Internal Revenue Code, or any federal government retirement program, the contributions to which were deductible from the taxpayer's federal adjusted gross income, but only to the extent the contributions to such plan or program were subject to taxation under the income tax in another state.

Section 58.1-202(1) gives the Tax Commissioner supervisory authority over Virginia tax law administration. Nielsen Co., LLC v. County Board of Arlington County, 289 Va. 79 (2015), recognizes agency discretion to fill in statutory gaps with reasonable methodologies.

The Department's pro-rata method is grounded in Internal Revenue Code § 72, which governs annuity taxation. Under § 72, each annuity payment is partially excluded from gross income based on the ratio of the taxpayer's investment in the contract to the expected return. The Department applied that ratio approach to retirement plan distributions.

Public Document 10-214 (Sept. 15, 2010) is the Tax Commissioner's ruling that formalized the pro-rata method. The taxpayer in that case had argued for cost-recovery, which is what Pennsylvania uses (61 Pa. Code § 101.6(c)(8)(iii)(B)). The Commissioner rejected the argument.

Common questions

Q: How does the pro-rata method actually work?
A: Take the total contributions originally taxed in another state and divide by the expected total payout (basically what IRC § 72 does for annuities). That gives the percentage of each Virginia distribution that's a return of contributions (subtractable) versus earnings (taxable in Virginia).

Q: Why didn't the General Assembly just specify the method?
A: The opinion doesn't say. The General Assembly could amend § 58.1-322.02(11) to pick cost-recovery or pro-rata explicitly. Until it does, the Department's reasonable choice gets administrative deference.

Q: Is pro-rata better or worse for retirees?
A: It depends on the timing. Pro-rata spreads the tax-free recovery over the entire payout period, so retirees pay some tax on each distribution from year one. Cost-recovery defers all tax until contributions are fully recovered, so early distributions are entirely tax-free. Cost-recovery is generally better for retirees who want to defer tax; pro-rata is better for the state's revenue smoothing.

Q: Does this opinion apply to traditional IRAs as well as 401(k)s?
A: Yes. Section 58.1-322.02(11) covers qualified pension/profit-sharing/stock bonus plans (IRC § 401), IRAs (IRC § 408), and deferred compensation plans (IRC § 457), plus federal government retirement programs.

Q: What does "subject to taxation under the income tax in another state" mean?
A: The subtraction is available only for contributions that were taxed by another state at the time they were made. So if you worked in Pennsylvania (which doesn't allow a deduction for retirement contributions; PA taxes them at contribution time) and then retired in Virginia, your distributions may qualify in part. If you worked in a state that did allow a deduction at contribution time, then the contributions weren't "subject to taxation" there and don't qualify for the subtraction here.

Q: Can a taxpayer challenge the Department's pro-rata methodology?
A: A taxpayer could refuse to follow it and litigate, but Nielsen and the deference doctrine for agency-filled gaps make the Department's choice hard to displace absent General Assembly action. The opinion is an administrative interpretation; courts would give it considerable weight.

Q: Does this matter for federal income tax?
A: No. The subtraction is purely a Virginia adjustment to federal AGI. The federal tax treatment of the distribution is unaffected.

Q: Does it apply only to multi-state retirees?
A: Yes, this specific subtraction does. The trigger is that contributions were "subject to taxation under the income tax in another state." A retiree who only worked in Virginia wouldn't qualify under this provision (though other Virginia retirement-income provisions may apply).

Citations

The opinion is built on § 58.1-322, § 58.1-322.02(11), and § 58.1-202(1); IRC § 72 (annuity ratio); the Department's Public Document 10-214 (Sept. 15, 2010); Pennsylvania's 61 Pa. Code § 101.6(c)(8)(iii)(B) and Oregon's Or. Rev. Stat. § 316.159(5)(a) and New Jersey's N.J. Stat. Ann. § 54A:6-10(a) as comparators; and Nielsen Co., LLC v. County Board of Arlington County, 289 Va. 79 (2015).

Source

• Landing page: https://www.oag.state.va.us/annual-reports-opinions/official-opinions
• Original PDF: https://www.oag.state.va.us/files/Opinions/2020/19-058-Deeds-issued.pdf

Original opinion text

COMMONWEALTH of VIRGINIA
Office of the Attorney General
202 North Ninth Street
Richmond, Virginia 23219
804-786-2071
Fax 804-786-1991
Virginia Relay Services
800-828-1120
7-1-1

Mark R. Herring
Attorney General

October 2, 2020

The Honorable R. Creigh Deeds
Member, Senate of Virginia
Post Office Box 5462
Charlottesville, Virginia 22905

Dear Senator Deeds:
I am responding to your request for an official advisory opinion in accordance with § 2.2-505 of the Code of Virginia.

Issue Presented

You ask whether the Department of Taxation has legal authority under current state law to adopt a pro-rata methodology for calculating the amount of a retirement plan distribution that represents the taxpayer's contributions to such plan for purposes of the subtraction from Virginia taxable income as provided in § 58.1-322.02(11) of the Code of Virginia.

Applicable Law and Discussion

A taxpayer's federal adjusted gross income forms the starting point for calculating the taxpayer's Virginia taxable income.[1] If a taxpayer's federal adjusted gross income includes certain retirement plan distributions, § 58.1-322.02(11) authorizes the following subtraction to compute Virginia taxable income:

Any income received during the taxable year derived from a qualified pension, profit-sharing, or stock bonus plan as described by § 401 of the Internal Revenue Code, an individual retirement account or annuity established under § 408 of the Internal Revenue Code, a deferred compensation plan as defined by § 457 of the Internal Revenue Code, or any federal government retirement program, the contributions to which were deductible from the taxpayer's federal adjusted gross income, but only to the extent the contributions to such plan or program were subject to taxation under the income tax in another state.[2]

The subtraction from Virginia taxable income authorized by this subsection is limited to "income ... derived from" certain qualified plans, where the contributions "were deductible" under the federal tax laws and "only to the extent the contributions" (as opposed to any income generated from those contributions) were already "subject to taxation" in another state. Section 58.1-322.02 does not prescribe the specific methodology to be used to calculate which portion of a plan distribution represents a taxpayer's contribution to the plan (which may be subtracted), and which portion represents income generated by those contributions (which may not be subtracted). The Department of Taxation has adopted a pro-rata approach to determine which portion of a retirement plan distribution represents contributions to the plan, and which portion represents taxable earnings. This approach is based upon the methodology prescribed by Internal Revenue Code § 72 to determine what portion of an annuity payment represents a taxpayer's nontaxable recovery of his investment in such annuity contract, and what portion of the payment represents taxable income.

In contrast to other states with tax regimes providing for similar subtractions for retirement plan distributions,[3] Virginia's taxing statutes are silent as to the manner in which the Department of Taxation shall calculate the portion of the distribution that represents a return of the employee's contribution. In P.D. 10-214,[4] the ruling referenced in your request, the taxpayer advocated for adoption of Pennsylvania's methodology, which uses a cost-recovery rule under which no portion of a retirement plan distribution is taxable until the taxpayer has recovered his contributions to the plan.[5] The Department of Taxation rejected that argument in favor of a pro-rata rule based on its determination that "a pro-rata approach more accurately reflects the nature of a distribution from a retirement plan."[6]

Although § 58.1-322.02(11) does not specify the methodology to be used by the Department of Taxation, the Tax Commissioner and Department of Taxation supervise administration of the Commonwealth's tax laws.[7] Absent a statutory directive requiring or prohibiting the use of a specific methodology, the Department is vested with discretion to determine how to calculate the subtraction authorized by § 58.1-322.02(11).[8]

Conclusion
Accordingly, it is my opinion that the Department of Taxation has discretion under current Virginia law to adopt a pro-rata methodology to calculate the amount of a retirement plan distribution that may be subtracted from Virginia taxable income pursuant to § 58.1-322.02(11).

With kindest regards, I am,
Very truly yours,

Mark R. Herring
Attorney General

1. VA. CODE ANN. § 58.1-322 (LexisNexis, current through 2020 Reg. Sess.).

2. Id. § 58.1-322.02(11) (LexisNexis, current through 2020 Reg. Sess.).

3. See OR. REV. STAT. § 316.159(5)(a) (current through ch. 19 of the 2020 First Spec. Sess.) ("For purposes of the subtraction allowed under subsection (1) of this section[,] ... [d]istributions received by the taxpayer from a plan or trust described in subsection (2) of this section shall be considered to initially consist of a recovery of contributions."); N.J. STAT. ANN. § 54A:6-10(a) (West, current with laws through L.2020, c. 61) ("Gross income shall not include that part of any amount received as an annuity under an annuity, endowment, or life insurance contract which bears the same ratio to such amount as the investment in the contract as of the annuity starting date bears to the expected return under the contract as of such date.").

4. VA. DEP'T OF TAXATION, Pub. Doc. No. 10-214 (Sept. 15, 2010), https://www.tax.virginia.gov/laws-rules-decisions/rulings-tax-commissioner/10-214.

5. See 61 PA. CODE § 101.6(c)(8)(iii)(B) (current through the August 2020 supplement changes effective through 50 Pa.B. 2826) ("To determine the portion of a distribution to be included in income, an individual shall use the cost recovery method.").

6. VA. DEP'T OF TAXATION, Pub. Doc. No. 10-214, supra note 4.

7. VA. CODE ANN. § 58.1-202(1) (LexisNexis, current through 2020 Reg. Sess.).

8. See Nielsen Co., LLC v. Cty. Bd. of Arlington Cty., 289 Va. 79, 96, 767 S.E.2d 1, 8-9 (2015).