Traditional 401(k) distributions are taxable on your federal return, and in most states that impose an income tax of their own, you'll end up including those distributions in taxable income for state purposes as well. But Pennsylvania is an outlier when it comes to retirees and taxes, and its favorable treatment of income from sources like retirement accounts and pensions means that many people don't have to pay state income tax at all on their retirement income. Still, there are some exceptions you have to keep in mind if you plan to take a 401(k) distribution as a Pennsylvania resident.

401(k)s in Pennsylvania: usually tax exempt
Pennsylvania income tax laws make most retirement and pension income exempt from state tax. The reason for this is that Pennsylvania typically doesn't allow you to exclude your 401(k) contributions from your state taxable income in the year you make them, again departing from the federal practice. From a policy standpoint, Pennsylvania lawmakers are willing to make the trade-off that having denied a tax break up front, it's reasonable to allow distributions to be tax-free -- even though they include the income the 401(k) generated during your career.

In effect, Pennsylvania forces all 401(k) participants into a system that resembles the Roth IRA or Roth 401(k). In a Roth, contributions aren't eligible for a tax deduction, but withdrawals in retirement are free of tax.

A word of warning
One thing that 401(k) participants need to be aware of, though, is that Pennsylvania does not give tax-free treatment to early distributions. Instead, distributions are treated as being made first from the amount you contributed, which doesn't generate any taxable income. If you withdraw more than your total contributions, then you'll pay state income tax on the excess.

One area of uncertainty has to do with the age at which you're allowed to take 401(k) distributions without facing this exception. On one hand, Pennsylvania law often points to age 59 1/2, which is the appropriate early withdrawal age for IRAs and certain other retirement accounts. Federal law allows for 401(k) distributions as early as age 55 under certain circumstances, but it's unclear whether Pennsylvania's rules allowing distributions when a worker has met the eligibility requirement for separation from service by retirement based on old age, infirmity, or long-continued service apply to 401(k) plans that set 55 as the earliest permitted distribution date.

What is clear, though, is that Pennsylvania doesn't recognize any federal exceptions that would avoid an early withdrawal penalty. For instance, some early distributions for a first-time homebuyer or medical expenses avoid a penalty for federal purposes, but they'd still be taxed in Pennsylvania.

The key takeaway is that Pennsylvania taxpayers should wait until age 59 1/2 to take 401(k) distributions if at all possible to avoid any uncertainty about how the provisions work. That gives you the full benefit of Pennsylvania's favorable treatment of 401(k)s.

We've touched a little here on IRAs, which you can roll 401(k)s into. If you'd like to learn more about these investment vehicles for retirement, make sure to visit the Fool's IRA Center.

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