In Magen v. Department of Treasury, the Michigan Court of Appeals held that the Michigan Department of Treasury cannot tax the principal balance of a 403(b) retirement account when it is transferred to an IRA upon retirement or even when it is later withdrawn from the IRA, because the principal balance was not taxable in the first place.
The state can pose an income tax on tax deferred income, such as interest and other gains, but there can be no tax on a principal balance that has always been non taxable. The court held, “[I]n this case the income placed into the IRA was not state- tax-deferred income; it was state- non-taxable income. Obtaining deferral on applicable taxes by rolling those monies over into an IRA does not create a deferred obligation to pay Michigan income tax on monies that were not subject to state income tax to begin with. . . . We can conceive of no rational basis to make such benefits taxable if placed in an IRA, but not if placed in an ordinary investment account or a bank or in a mattress.”
See HERE for the full opinion.