New York Advisory Opinion TSB-A-84 (1)I: If an IRA's funds are invested entirely in tax-exempt New York and Puerto Rico municipal bonds, is the IRA distribution still tax-exempt when withdrawn?

Plain-English summary

Richard W. Kaszubinski asked whether any part of a distribution from an IRA is tax-free if the IRA's entire corpus is invested in New York or Puerto Rico municipal bonds and obligations - securities whose interest is normally exempt from federal (and New York) income tax.

The Department explained that normally, interest on state, territorial, or possession obligations (including Puerto Rico bonds) is excluded from federal gross income under Internal Revenue Code § 103. But IRAs are governed by a separate rule: IRC § 408(d) requires that any amount distributed from an IRA be included in the recipient's gross income for the year received, full stop. Once municipal bond interest is earned inside an IRA, it loses its identity as "interest" altogether and instead becomes simply "a distribution from an IRA" - a different category of income under the federal Code, even though the Code doesn't give that category a distinct name of its own.

Because Tax Law § 607 requires New York's Article 22 terms to carry the same meaning as their federal counterparts (absent a clearly required different meaning), that federal recharacterization carries over to New York: since the IRA distribution isn't treated as "interest" for federal purposes, it isn't treated as "interest" for New York purposes either. That matters because New York's own exemption for municipal bond interest (the subtraction under Tax Law § 612(c)(6), along with the related U.S.-obligations subtraction) only applies to income that retains its character as tax-exempt "interest" - which an IRA distribution no longer is. The Department did note that the general $20,000 IRA exclusion under section 612(c)(3-a) remains available on this distribution (unless it's a lump-sum distribution subject to the separate section 601-C tax), but that's a different, general IRA benefit - not a preservation of the municipal bonds' original tax-exempt character.

What this means for you

Individuals holding tax-exempt municipal bonds inside an IRA

Don't expect the bonds' tax-exempt status to carry through to your IRA distributions. Once municipal bond interest is earned inside the IRA, IRC § 408(d) recharacterizes the entire distribution as ordinary IRA income when withdrawn - the underlying investment's tax-exempt character doesn't survive the trip through the IRA.

Investors deciding whether to hold municipal bonds inside vs. outside a retirement account

Holding tax-exempt bonds inside an IRA converts their otherwise tax-free interest into fully taxable ordinary income upon distribution (subject to the general $20,000 IRA exclusion) - a materially different result than holding the same bonds directly, where the interest would stay exempt.

Accountants advising clients on IRA asset allocation involving municipal bonds

Flag that IRC § 408(d)'s blanket inclusion rule for IRA distributions overrides the municipal-bond exemption once the interest passes through the IRA - New York follows the same federal characterization under Tax Law § 607, so there's no independent state-law escape hatch either.

Common questions

Q: My IRA is invested entirely in New York municipal bonds - is my IRA distribution tax-free?
A: No. Once municipal bond interest is earned inside an IRA, federal law (IRC § 408(d)) requires the entire distribution to be included in gross income as ordinary IRA income, not as tax-exempt interest - and New York follows that same characterization.

Q: Can I still claim New York's exclusion for interest on tax-exempt obligations?
A: No, not on this distribution - that subtraction (Tax Law § 612(c)(6)) only applies to income that retains its character as tax-exempt "interest," and an IRA distribution has already been recharacterized as ordinary income under federal law.

Q: Is there any tax break at all available on this distribution?
A: Yes, but a different one: the general $20,000 IRA exclusion under section 612(c)(3-a) still applies to this distribution (unless it's a lump-sum distribution taxed separately under section 601-C) - it just isn't tied to the bonds' original tax-exempt status.

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/income_ao_1984.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/income/a84_1i.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-A-84 (1) I
Income Tax
October 8, 1984

STATE OF NEW YORK
STATE TAX C0MMISSION
ADVISORY OPINION

PETITION NO. I820809A

On August 9, 1982, a Petition for Advisory Opinion was received from Richard W.
Kaszubinski, 404 North Main Street, North Syracuse, New York 13212.
The issue raised is whether any portion of distributions from an Individual Retirement
Account, the corpus of which is invested solely in New York or Puerto Rico municipal bonds and
obligations, is subject to tax under the Personal Income Tax imposed by Article 22 of the Tax Law.
Section 612 of the Tax Law, contained in Article 22 thereof, provides that the New York
adjusted gross income of a resident individual, the starting point in determining his New York
taxable income, means his Federal adjusted gross income, with certain modifications.
Section 103 of the Internal Revenue Code excludes from Federal gross income, and thus from
Federal adjusted gross income, "interest on . . . the obligations of a State, a territory, or a possession
of the United States, or any political subdivision of any of the foregoing, or of the District of
Columbia .... " Interest on bonds issued by the government of Puerto Rico or by its authority is
similarly exempt. 48 U.S.C. § 745; 26 U.S.C. §103(a), (m). However, Section 408(d) of the Internal
Revenue Code provides that "any amount paid or distributed out of an individual retirement account
. . . shall be included in gross income by the payee or distributee, as the case may be, for the taxable
year in which the payment or distribution is received." Thus, where the funds contributed to an I.R.A.
are invested in municipal bonds the interest on which is ordinarily excluded from gross income under
Section 103, such interest upon its exiting the I.R.A. loses its character as tax-exempt interest and
takes its place, as ordinary income, in Federal gross income and adjusted gross income, and is thus
subject to the Federal income tax. This is, the Code characterizes the distribution from the I.R.A. as
a species of income different from exempt municipal bond interest, albeit without giving such
income a distinct name. Section 607 of the Tax Law provides that terms used in Article 22 are to be
given the same meaning "as when used in a comparable context in the laws of the United States
relating to federal income taxes, unless a different meaning is clearly required." Thus, the Internal
Revenue Code's exclusion of the income in question from the category of "interest" in effect means
that it is not to be treated as interest for purposes of Article 22. Thus, in computing New York
adjusted gross income, the modifications provided for in Tax Law, § 612(c)(6), which requires a
subtraction from Federal adjusted gross income of "interest" income on obligations or securities to
the extent exempt under New York law, and § 612(c)(i), which provides for a similar modification
with respect to obligations of the United States and its possessions, are inapplicable.

RODERICK G. W. CHU, COMMISSIONER
TP-8 (3/83)

GABRIEL B. DiCERBO, DEPUTY COMMISSIONER
FRANK J. PUCCIA, DIRECTOR

-2­
TSB-A-84 (1) I
Income Tax
October 8, 1984

Petitioner next inquires as to the manner in which distributions from an IRA are to be
reported for purposes of the New York Personal Income Tax. As indicated above, distributions from
an IRA are included in Federal adjusted gross income and are therefore automatically included in
New York adjusted gross income. However, section 612(c)(3-a) of the Tax Law provides for an
exclusion of up to $20,000, applicable to IRA distributions, except those which constitute lump sum
distributions within the meaning of § 402(c)(4)(A) of the Internal Revenue Code and which are taxed
under Tax Law, § 601-C (separate tax on the ordinary income portion of lump sum distributions).

DATED: April 16, 1984

s/FRANK J. PUCCIA
Director
Technical Services Bureau

NOTE: The opinions expressed in Advisory Opinions
are limited to the facts set forth therein.