There have been many threads over the years that have questioned how NJ Tax Law works for the exemption income derived from Federal Obligations (aka USGO) and NJ state-specific Obligations.
I created this post to summarize my current (as of April 2023) understanding of the law, the supporting documentation, and the impacts related to investing.
Context
- NJ Gross Income Tax law regarding Federal and State Obligations is unique among the 50 states.
- Do not apply what you hear about another state to NJ, it will be wrong.
- In particular, the NJ Qualified Investment Fund (QIF) requirement is quite different than 50% threshold requirement imposed by the states of CA, NY and CT.
- NJ defines Federal Income, also known as US Government Obligations (USGO), in the accepted manner of most other states. Vanguard and other brokerages annually publish data on the amounts of USGO held and portion of income derived from their funds. This is basis of all tax calculations discussed here.
Exempt Interest Income
- Interest Income derived from Federal or NJ State Obligations are exempt from NJ Income tax.
- But, if the income is received via a Mutual Fund, there is special treatment to be considered.
- This special treatment is documented in the NJ GIT-5 by a concept called a Qualified Investment Fund (QIF)
- The primary requirement is that the fund must invest 80% or more of its funds (other than cash or receivables) in securities that are exempt from New Jersey Income Tax.
- Income from the fund derived from interest from US Government Obligations is exempt from NJ tax regardless of the fund's QIF status.
- Income from the fund derived from interest from NJ State-Specific Exempt Obligations is exempt from NJ tax only if the fund is a QIF.
Capital Gains
- Capital Gains (CG) from distributions or Disposal of Property (such as selling shares for a gain) of both NJ Obligations and USGO is exempt from NJ Income Tax.
- If the CG is received via a Mutual Fund, the exemption is subject to the 80% threshold requirement for both NJ Obligations and USGO.
- Note, Vanguard publishes which funds meet the NJ QIF threshold annually. I have had difficulty finding published reports from Fidelity.
IRA Withdrawals
- NJ, allows an exemption for exempt income received via distributions from IRAs and 401K accounts. This a rare exemption only available in a few states.
- This allowance is documented in the NJ GIT-1&2.
- IRA distributions of USGO and NJ Exempt interest income are subject to the same rules as for taxable investments.
- IRA CG distributions from mutual funds are subject to the same 80% threshold requirement for both NJ Obligations and USGO as for taxable investments.
- I have started a thread on Bogleheads regarding this allowance and how to handle reporting in light of the limited guidance provided by the NJ Division of Taxation and the record keeping complexity suggested by the rules.
- The thread can be found here: https://www.bogleheads.org/forum/viewtopic.php?t=393132
History of the QIF
This is my understanding from an old post to BH that I cannot find anymore.
The oddity here is that the QIF law was written nearly 3 decades ago and it applies to ALL exempt income, but a series of lawsuits resulted in the NJ Supreme Court recognizing that Federal obligations could not be subject to this limitation and still be in compliance with Federal law. Therefore, an exception was made for Federal obligations.
If you understand this context, the language in GIT-5 makes sense as it reflects the law as written, but adjusted by the Federal obligations caveat imposed by judicial review.
Examples
Treasury Money Market Fund
- The fund company publishes that 75% of the distributions are source by USGO.
- The investor received $100 in dividends from the fund.
- For that year, $75 would be exempt from NJ Gross Income Tax and $25 would be taxable.
Municipal Money Market Fund
- The fund is a National Muni fund that invests in assets of all 50 states and various territories.
- 1% of the distributions are source form NJ Exempt Obligations.
- The investor receives $100 in dividends from the fund.
- For that year, $0 would be exempt from NJ Gross Income Tax and all $100 would be taxable.
- The income is still exempt from Federal Income taxes as expected.
NJ State-specific Municipal Money Market Fund
- The fund is a NJ-specific Muni fund that invests in assets from NJ and other source.
- 85% of the distributions are source form NJ Exempt Obligations and 8% are source from USGO.
- The investor receives $100 in dividends from the fund.
- For that year, $93 would be exempt from NJ Gross Income Tax and $7 would be taxable.
Short-term US Treasury Bond Fund
- The fund invests 100% of it assets in short-term US Treasury bills and notes.
- The investor receives $100 in dividends and STCG distributions and $15 in LTCG distributions.
- For that year, $115 would be exempt from NJ Gross Income Tax and $0 would be taxable.
Total Bond Market Index Fund
- The fund invests 35% of it assets in various US Treasury bills and notes
- The investor receives $100 in dividends and STCG distributions and $15 in LTCG distributions.
- For that year, $35 would be exempt from NJ Gross Income Tax and $80 would be taxable.
- The LTCG are not exempt from tax as the fund does not meet the QIF criteria.
- As best I can tell, STCG are not separated out by the 1099 reporting, so I just treat them as dividends. This may not be technically correct.
Total Stock Market Index Fund
- The index fund invests 1% of it assets in various US Treasury bills and notes as part of the funds daily liquidity needs.
- The investor receives $100 in dividends and $2 in LTCG.
- For that year, $1 dividends would be exempt from NJ Gross Income Tax and $99 would be taxable.
- The $2 LTCG would not be exempt from tax as the fund does not meet the QIF criteria, thus taxable.
