A state Senate committee considered emergency legislation yesterday to bail out about 1,400 state employees who were hit with unexpected federal taxes when they withdrew their money from the state retirement system and put the funds into Individual Retirement Accounts.
The bill, which is expected to gain swift legislative approval, would allow those employees to transfer back into the state retirement system the money they had withdrawn and put into IRAs, avoiding heavy taxes.
The Internal Revenue Service, in an unusual move, has already agreed to allow this transfer-back and forgive taxes on the withdrawals, said Herbert L. Dyer, head of the Maryland State Retirement Agency.
"We're throwing a life ring in the water for them [employees] to grab if they want it," he said.
State employees and teachers who pulled their money out of the retirement plan from 1987 through 1989 and put it into tax-sheltered IRAs were shocked to learn last year that the transfer was not eligible for a tax-free rollover.
In many cases, they owed more than half their lifetime retirement savings in taxes and penalties, plus interest. If they then tried to pull the money out of the IRA to pay their taxes, that money would have been subject to another series of taxes and penalties, Mr. Dyer noted.
"He could end up owing 125 percent in taxes on the original amount," the retirement chief said yesterday, after testifying before the Senate Budget and Taxation Committee.
Many of the 1,435 state employees and teachers who withdrew their money from the old retirement system after 1986 claimed they were misled by the state retirement agency into thinking that the withdrawals rolled over into IRAs would be tax-free.
Several lawsuits charging negligence have been filed against the state retirement agency, seeking millions of dollars in damages. Federal legislation to forgive the taxes due from these Maryland employees failed during the last session of Congress.
When the state created a new pension system in 1980 to save money, many employees were encouraged to withdraw their contributions and interest from the old retirement system and switch to the new plan.
The new pension plan paid lower benefits but did not require employee contributions.
Before 1986, there was no tax problem with the withdrawals. But a new federal tax law effective in 1987 made withdrawals placed in IRAs taxable and subject to penalties.
Coincidentally, the interest rate paid on withdrawals from the old pension plan began to soar after 1986, enticing longtime employees to make withdrawals.
This fiscal year, for example, the retirement system pays 15.7 percent on contributions.
The withdrawals also ballooned, from an average $5,000 in the early 1980s to nearly $150,000 last year.
That attracted the attention of the IRS, which got a court order last December to obtain the names of people making withdrawals after 1986 from the state plan.
Mr. Dyer said the state legislation would not affect several hundred employees who made withdrawals in 1990, because they can take the money out of their IRAs before April 15 and cure their own tax problems.
The old retirement system still has about 45,000 participants, while the new pension system covers 115,000 state employees and teachers, Mr. Dyer said.
Meantime, the IRS recently approved the tax-free transfer of funds by state employees from the old retirement system to a new state-run 401k savings retirement plan starting Jan. 1. That would allow participants to cash out of the old fund with high interest earnings and put the money tax-free into the supplemental state plan, avoiding a tax predicament.