IRAs are a great way to save for retirement, and traditional IRAs give you an up-front tax break you can use to reduce your current-year taxes. Our IRA Center can help you learn a lot more about how to get the most out of these investment vehicles, but here's something to know right now: When you retire, you typically have to pay federal income tax on the amount you withdraw from a traditional IRA.

Not every state follows the same rules on IRAs with their state income tax systems. In Kentucky, for instance, IRA withdrawals often qualify for an exemption from state income tax. Let's take a closer look at the provision and how you can use it to your advantage.

U.S. vs. Kentucky
In the federal tax system, when you take a withdrawal from a traditional IRA, it's almost always fully taxable. The only situation in which it isn't is if at some point you made a nondeductible contribution to your traditional IRA, and that's relatively rare.

However, Kentucky has a special provision regarding pension income. All pension and retirement income paid under a written retirement plan is eligible for exclusion for Kentucky income tax purposes up to a certain annual limit. This exclusion includes pensions, annuities, 401(k), and other deferred compensation plans, as well as death benefits, disability retirement benefits, and income received from converting a traditional IRA to a Roth IRA. The exclusion also specifically includes IRA accounts.

For 2015, the maximum amount of eligible pension income that you can exclude was $41,110. If you had less than that amount of income when you combine IRA withdrawals in retirement with the other eligible income from sources listed above, then all of your pension income will be exempt from Kentucky income tax. If you had more than $41,110, then a portion of your income will still be taxed in Kentucky.

Interestingly, Kentucky appears to allow taxpayers to take the exemption for IRA withdrawals even if they haven't actually retired. Section 141.010(10)(i)(3) includes any withdrawal from an IRA within the definition of excludable distributions, without any mention of when they were made or the age of the recipient. This differs from certain other states, in which there's a distinction between retirement income from a timely IRA withdrawal and non-retirement income from an early IRA withdrawal that's subject to federal penalties.

Overall, Kentucky's laws on IRA distributions are extremely favorable to retirement investors. Being able to exclude much or all of your retirement income from state income tax is a point in Kentucky's favor in appealing to its lifelong residents and to those considering a move to the state after they choose to retire.

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