In a remarkable reading of its statute, the Massachusetts Department of Revenue (DOR) has issued Directive 08-3 that will require all unincorporated business owners and partners who make either an elective deferral or receive a matching contribution in a qualified 401(k) plan to withhold state income tax.

Unless corrected by the state legislature, this short-sighted decision will cost the state and its residents dearly in the future. Since the taxation occurs currently, the future retiree distribution will not be taxable. Given the large number of state residents who will be affected by this interpretation (particularly baby boomers), the state will collect slightly more money today and substantially less money as retirement funds are withdrawn over the next 10 to 30 years.

Further, how many small business owners will establish plans for their employees knowing that they will be taxed on their own contributions by the state?

Hopefully, the Massachusetts legislature will figure this out shortly and correct its tax code.