Kentucky's tax laws clearly state that all retirement income may be eligible to be excluded from state income taxation. The state imposes a limit on what can be withdrawn annually but sets this maximum as an addition to other income. Furthermore, the origin of the retirement income and type of account determines whether Kentucky taxes the distributions. Individual retirement accounts (IRAs) are generally subjected to Kentucky taxation following federal guidelines.
Kentucky requires taxpayers who receive income from pensions and retirement plans to complete Schedule P as part of the state income tax return if the total amount exceeds state limits and the taxpayer is a retired government worker or receives benefits from a railroad retirement plan. For the 2010 tax year, the maximum amount of retirement income eligible for exclusion was $41,110 for Kentucky taxpayers. In addition, taxpayers who must file Form 4972-K, to calculate tax on a lump-sum distribution, must complete Schedule P. Otherwise, the state follows federal treatment of IRA distributions and additional retirement income.
Under federal guidelines, contributions to a traditional IRA are taxable at the time of withdrawal or distribution. Conversely, distributions from Roth IRA contributions are tax-exempt. When doing a conversion from a traditional IRA to a Roth, half of the income in the rollover was taxable for 2011 and half for 2012. Therefore, federal treatment of withdrawals from IRA accounts differs depending on the type of IRA from which the money is withdrawn. If the withdrawals are reported on federal tax returns, this may be transferred to Kentucky state income tax returns.
Account holders who receive funds from an IRA account should receive federal income tax form 1099-R. This information form, which reports distributions from IRAs, shows the amount of the withdrawal. Both the account holder and administrator report information on a 1099-R to the IRS. However, the administrator of the account may not know what portion of the distribution, if any is taxable. For both federal and Kentucky income tax purposes, the taxpayer will need to follow the instructions on federal form 1040 to figure what portion, if any, is taxable income.
For tax year 2010, the IRS required taxpayers who took early distributions from traditional IRA accounts to file Form 5329 to report earnings. Withdrawals from a traditional IRA may be subject to a 10-percent federal tax, depending on the circumstances of the withdrawal. Line 15(b) of federal Form 1040 is where the taxable amounts of IRA distributions are reported, and according to Kentucky tax regulations, these amounts are eligible for exclusion from Kentucky taxation. Chapter 141 of the Kentucky Revised Statutes (KRS) outlines the state's income tax laws as they differ from federal regulations. KRS 141.010, states that "any distribution" from an IRA as it is defined in the IRS code qualifies for exemption under Kentucky tax laws up to the $41,110 annual total.