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If you are receiving a federally taxable retirement plan distribution under the former federal FERS system and you had at least 5 years of creditable service as of 8/12/89 (yes, thats 1989) then you may exclude ALL of your benefits from N.C. taxation. Report the deduction on line 42 of N.C. Individual Income tax return form D-400. No such FULL exemption is available for retirement distributions from plans of other states.
If you do not qualify for this exemption both you and your wife will qualify for N.C.'s general retirement deduction of up to the lesser of your taxable retirement distributions or $4,000 each. Thus, you may report a reduction in your N.C. taxable income of up to $8,000 for retirement plan benefits you receive that are taxable for Federal purposes. This deduction is reported on line 43 of Form D-400.
To the extent your retirement benefits are exempted on line 42, you may not take an additional deduction on line 43. Thus, if your benefits are exempt completely on line 42 because you qualified, then you may only take a $4,000 deduction on line 43 to reduce your wife's taxable retirement benefits.
Here is a link to the form http://www.dor.state.nc.us/downloads/D400_D400TC.pdf.
Also, here is a link to the D-400 instructions http://www.dor.state.nc.us/downloads/D401.pdf. See page 10 for a discussion of the retirement benefit exclusions.
Because it is impossible for me to identify and consider ALL the relevant facts, this advice is not intended or written to be used for the purpose of avoiding penalties, and cannot be used for that purpose.
The civil service retirement system is also eligible to be excluded fully under the North Carolina Bailey Supreme Court decision if you had the requisite 5 years of credited service as of 8/12/89. Thus, if you met the credited service requirement you may fully exclude your CSRS retirement benefits from N.C. income taxes. To claim this deduction you must enter on line 42 of form D-400 the amount of your CSRS retirement benefits taxed for Federal purposes. Your wife's MD retirement benefits are not eligible for this exclusion (see below).
If you do not qualify for the full exemption under the Bailey decision, you and your wife may exclude up to a maximum of $4,000 each from N.C. income taxes under the general retirement benefit exclusion. This exclusion is available to everybody who receives retirement/pension benefits. To claim this deduction you enter the lesser of your retirement/pension benefits taxable for Federal purposes r $4,000 for each of you. Thus, if you received $8,000 in benefits and your wife received $5,000, your max exclusion on line 43 is $8,000. Alternatively, if you received $8,000 and your wife only received $3,000, then your exclusion would be $7,000. Remember, if you fully excluded your benefits under the Bailey decision on line 42, you may not take the $4,000 for YOUR benefits. You may still take the exclusion for your wife's benefits.