What Is the Bailey Act? Qualifying Plans and NC Tax Deduction

The Bailey Act, more precisely known as the Bailey settlement, is the reason many North Carolina retirees pay no state income tax on their government pensions. Under the NC retirement tax exemption that grew out of Bailey v. State of North Carolina, any distribution you receive from a qualifying state, local, or federal government retirement plan is fully deductible from your North Carolina taxable income, provided you were vested in that plan by August 12, 1989.¹ The protection is permanent, and it passes to your beneficiaries.

Where the Exemption Came From

For years, North Carolina promised its public employees that their retirement benefits would never be taxed by the state. In 1989, the legislature reversed course and started taxing them. Retirees and employees sued, and the North Carolina Supreme Court ultimately held that the 1989 legislation was an unconstitutional impairment of contract.² The resulting settlement permanently bars the state from taxing retirement benefits for anyone who had already earned the state’s promise. The General Assembly then wrote the exclusion into N.C. Gen. Stat. § 105-153.5(b)(5).³

Do You Qualify? The August 12, 1989 Vesting Test

Everything hinges on your status on one date: August 12, 1989. For a traditional government pension like the Teachers’ and State Employees’ Retirement System or a federal CSRS or FERS pension, vesting means you had completed five or more years of creditable service by that date.¹ Hit five years by then, and every future dollar from that system is exempt. Fall short, even by a month, and nothing from that system qualifies, no matter how long you ultimately worked. The Department of Revenue draws a hard line, and there is no close-enough.

Once you meet the test, your status is locked in. You can leave government work, move away, change careers; the exemption still applies when you eventually draw the pension. Anyone who first joined a qualifying system after August 12, 1989, is outside the settlement entirely, and their retirement income is taxed at North Carolina’s flat 3.99% rate for tax year 2026.⁴

Different Rule for State 401(k) and 457 Plans

The five-year test does not apply to contribution-based plans. If you participated in North Carolina’s Supplemental Retirement Income Plan (the state 401(k)) or the state Deferred Compensation Plan (the 457), you were considered vested if you had contributed, or contracted to contribute, any amount by August 12, 1989.⁵ A single contribution on August 11, 1989 covers every future withdrawal from that plan. A first contribution on August 13, 1989 covers none of them.

Which Retirement Systems Qualify

The NCDOR identifies the following defined benefit plans as covered by the settlement:¹

North Carolina Teachers’ and State Employees’ Retirement System
North Carolina Local Governmental Employees’ Retirement System
North Carolina Consolidated Judicial Retirement System
Federal Employees’ Retirement System (FERS)
United States Civil Service Retirement System (CSRS)

Military retirees qualify if they had five or more years of creditable service by August 12, 1989. The statute broadly covers “State, local, or federal government retirement plans” exempt under the settlement, so other government systems within the court order’s scope may qualify as well.³ Private pensions, traditional IRAs, and other retirement accounts not tied to these government systems do not qualify.

How to Claim the Deduction

Your qualifying retirement income arrives on a Form 1099-R and is included in your federal adjusted gross income. On your North Carolina return, you subtract it on Line 20 of Form D-400 Schedule S, in the Deductions from Federal Adjusted Gross Income section. Enter the full amount of your qualifying distributions, attach Schedule S to your Form D-400, and include a copy of the 1099-R (or W-2 where applicable) to support the deduction.⁶ The Department of Revenue cross-checks claims against records held by each retirement system, so make sure your 1099-R reflects the correct plan.

Federal Tax Is Not Affected

The exemption is a North Carolina rule only. Your government retirement distributions remain fully taxable on your federal return, and the IRS does not recognize the Bailey settlement.¹ The Schedule S deduction exists precisely because North Carolina starts from federal AGI; the state is subtracting back out what the federal government has already included.

Rollovers Can Wipe Out the Exemption

This is where retirees most often lose the benefit by accident. Bailey protection lives in the qualifying account, not in the money. Roll Bailey-exempt funds into a traditional IRA or any other plan you were not vested in by August 12, 1989, and future distributions from that new account are fully taxable in North Carolina.¹ The dollars don’t carry the exemption with them.

Roth rollovers are the exception. If you convert Bailey-exempt funds into a Roth account, the rollover distribution itself stays exempt from North Carolina tax to the extent it was included in your federal income, a rule that has applied since January 1, 2008.¹ Beyond that, leaving the money in the qualifying account is almost always the safer move. Confirm the tax treatment of any proposed rollover in writing before you authorize it.

Beneficiaries Keep the Exemption

When a Bailey-qualified retiree dies, distributions from the qualifying account remain exempt from North Carolina income tax for whoever receives them, whether a surviving spouse, a child, or any other named beneficiary.⁷ The Department of Revenue has confirmed in private letter rulings that the protection extends through successive beneficiaries. If a surviving spouse later dies and passes the account on, those distributions are still exempt. Multiple beneficiaries each receive their share tax-free. The form of payment doesn’t matter either; monthly payments and one-time lump sums are treated the same as long as the money comes directly from the qualifying account.⁸

A separate scenario covered by Directive PD-99-2: if a vested employee dies while still working, distributions to their beneficiaries from the qualifying system are also exempt. The Department concluded it would be improper to tax those death benefits when the same funds would have been exempt had the employee lived to retire.⁸

Missed the Deduction on a Past Return?

If you qualified in a prior year but paid North Carolina tax on the income anyway, you can amend. File Form D-400 with Form D-400 Schedule AM attached, along with a corrected Schedule S showing the deduction on Line 20, and include a copy of the Form 1099-R.⁶ The refund window is the later of three years after the return’s due date or two years after you paid the tax.⁹ Past that, the money is gone. Pull your old returns and check now.

A Separate Path for Military Retirees

Military retirees who meet the Bailey vesting test have always qualified. Starting with tax year 2021, North Carolina added a separate deduction for certain military retirement payments under Session Law 2021-180, and it does not depend on the August 12, 1989 vesting date.¹⁰ If you served in uniform and don’t meet the Bailey cutoff, check whether you qualify under the newer provision instead. The two exemptions are independent; claim whichever one fits your service record.

1
NCDOR. Bailey Decision Concerning Federal, State and Local Retirement Benefits
2
Justia. Bailey v. State of North Carolina
3
North Carolina General Assembly. North Carolina General Statutes 105-153.5
4
NCDOR. Tax Rate Schedules
5
North Carolina Department of Justice. Qualification for Class Membership in Bailey/Emory/Patton Lawsuits
6
NCDOR. North Carolina Individual Income Tax Instructions
7
North Carolina Department of Revenue. Request for Private Letter Ruling – Bailey Settlement
8
NCDOR. Directive PD-99-2
9
North Carolina General Assembly. North Carolina General Statutes 105-241.6 – Statute of Limitations for Refunds
10
NCDOR. Military Retirement