State income taxes can play a substantial role in your financial planning, and state rules don't always match up with federal tax law. In Pennsylvania, favorable tax laws make a lot of pension and retirement income exempt from state income tax even if the IRS forces you to include it in your taxable income for federal purposes. However, even Pennsylvania puts limits on its exemption for retirement income, and different rules apply if you take withdrawals from your IRA early.

The general rule in Pennsylvania
Most retirement and pension income is exempt from Pennsylvania income taxes. For traditional pensions, you must have reached the eligibility requirement for separation from service by retirement based on old age, infirmity, long-continued service, or a combination of those factors.

Pennsylvania also has favorable treatment for IRAs. Distributions from an IRA are not taxable for Pennsylvania purposes if the payments are received on or after reaching the age of 59-1/2. In addition, any payments made to the estate or designated beneficiary of the IRA owner because of the owner's death are free from Pennsylvania income tax.

Early withdrawals: no exceptions
IRA distributions received before turning 59-1/2 aren't eligible for the exemption and are therefore fully taxable under Pennsylvania income tax law. This is the case even if you've retired from work before reaching age 59-1/2.

Moreover, even though some situations would prevent you from having to pay early withdrawal penalties on early distributions for federal tax purposes, Pennsylvania doesn't recognize those exceptions for state tax purposes. For instance, IRA owners can receive substantially equal periodic payments before age 59-1/2 without paying an early withdrawal penalty, but Pennsylvania imposes tax on distributions made using that method. Similarly, federal penalty exceptions for items like a first-time home purchase don't apply in Pennsylvania.

Finally, Pennsylvania taxes certain distributions from Roth IRAs if they're made before reaching age 59-1/2. Taxpayers have to pay tax if their withdrawal exceeds the amount of contributions that were previously subject to Pennsylvania income tax.

The obvious solution for Pennsylvania taxpayers is to do whatever you can to avoid taking IRA withdrawals before reaching age 59-1/2. Doing so will prevent you from having to include those withdrawals in your state taxable income and preserve more of your money for tax-free treatment in retirement.

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