Kentucky Pension Exclusion 2018

KENTUCKY’S  PENSION  EXCLUSION

May, 2018

One advantage to contributing pre-tax money to 401(k) plans, 403(b) plans, IRAs, and 457(b) plans is the ability to defer all state and federal income taxes until the money is withdrawn at retirement, when the taxpayer may possibly be in a lower tax bracket.  However, most Kentuckians may not be aware of a special tax advantage to retirement in Kentucky.  Years ago, when the state used to exempt its own employees' retirement income from state income taxes, the courts decided that the state could not treat its own employees' retirement income any different from other resident's retirement income.  The compromise was to exempt a certain amount of everyone's retirement income from the state income tax.  For 2018 this exemption is $31,110 per year taken from any qualifying plan (whether the benefit was funded by employee dollars or employer dollars).  Since most people expect to have less in retirement income than their pre-retirement income, and because the median household income in Kentucky is under $45,000, the vast majority of Kentucky residents can expect to benefit from deferring state income taxes into various retirement programs.

The State of Kentucky passed a comprehensive tax reform package in April that creates a 5% single rate individual income tax.  Consequently, Kentucky workers, who will have less than $31,110 in annual income from qualifying retirement plans, can totally eliminate the Kentucky income tax of 5% on both the money they contribute to these plans and the future investment gains on those dollars.

There is no minimum retirement age required to take advantage of this rule.  However, the 10% federal excise tax that normally applies when withdrawing funds prior to age   59 ½ will mean that it is normally not worth tapping these funds prior to that age.  Unlike the Federal Savers Credit, which benefits only lower paid individuals, this Kentucky “pension exclusion” can benefit a larger number of people --- low- and middle-income households.

In fact, it appears that someone over age 59 ½, who can benefit from this rule and who is permitted to take in-service withdrawals from his employer’s retirement plan, could contribute the maximum, paying no state income tax on the deferral, and then turn around and take it right back out of the plan, avoiding the 5% state income tax, as long as the total annual withdrawal from all retirement plans is less than $31,110.  We suggest individuals talk with their tax advisors before taking advantage of this tax break.