State Income Tax and Retirement Income

On only a few rare occasions does it make sense to defer money to your 401(k) or other employer sponsored plan instead of a Roth IRA. Those occasions include when your gross income excludes you from contributing directly to a Roth IRA (you can still convert), you are currently at a very high tax rate or the case of when you live in a state where retirement income is excluded from state taxation.

Here in Illinois, the current law exempts retirement income from being taxed at the state level. What this means, is that any contributions to a 401(k), 403(b), SEP, SIMPLE and 457 avoid state income taxation. Qualified distributions at retirement are only taxed at the federal level, and then only as income.

If you contribute directly to a Roth IRA that money is after-tax money going in. After-tax in this case meaning it’s been already taxed at the federal and state level. So in this case the money going into the Roth IRA has been “hit twice” with federal and state taxes.

One possible way to avoid this double whammy (going by current Illinois law) is to contribute to your employer’s plan and then at retirement or whenever you leave your job, convert that money to a Roth IRA. In this case the money from your paycheck is already deferred from state taxation and then when it’s converted to a Roth IRA, avoids state income taxation again – since it’s income from a retirement plan and considered retirement income – which Illinois does not tax. This is evidenced by the 1099-R you’ll receive at the time of conversion.

Another way to avoid this is if your employer’s plan allows, convert your 401(k) to a Roth 401(k) while you’re still employed. Again, you’ll pay federal income tax but avoid the state taxation if your state excludes retirement income for tax purposes. If you’re in a higher tax bracket, you may consider staging your conversions up to the point where you maintain low tax costs (converting small amounts over many years). Or you may just want to wait to convert the whole amount when you know you’ll be in a lower tax bracket.