Your wages are subject to federal and possibly state income tax. You can delay taxation by parking money in a 401(k) retirement account, but expect to pay taxes when you make withdrawals. Taxation of 401(k) plans and other retirement plans varies tremendously from state to state. However, even states with high tax rates sometimes allow certain exemptions for retirement plan withdrawals.
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A 401(k) is a defined contribution retirement plan. You and your employer can invest in the account on an annual basis up to maximum contribution limits. Funds are invested in stocks, bonds and other investment types. Your account balance may fluctuate over time. Unlike traditional pensions, 401(k) plans offer no growth or minimum withdrawal guarantees. You can deposit money into a 401(k) on a pretax or after-tax basis. This means you pay income tax before you make the investment or at the time of your withdrawal. Either way, the money inside the plan grows without being taxed until it's withdrawn. You typically incur federal tax penalties if you make withdrawals before the age of 59 1/2.
At the state level, 401(k) withdrawals are subject to income tax. Some municipalities and counties also assess an additional level of income tax. A number of states, including Alaska and Florida, have no income tax. This means you only have to contend with federal income taxes, though some municipalities or counties also tax income. In 2014, Nebraska assessed a 2.46 percent income tax on earnings of as little as $3,000; the tax rate for single filers who earned more than $29,000 was 6.84 percent. Tax-deferred 401(k) withdrawals are taxed as ordinary income, so these rates would apply to your retirement plan withdrawals. Basically, your net retirement income would be less if you lived in Nebraska rather than Florida.
Some states offer exemptions for retirees that could reduce your 401(k) tax burden. In Kansas, pension withdrawals, including those from 401(k)s, are tax exempt if you work for the civil service, the state or the railroads. As of 2014, taxation on income and 401(k)s from other sources in Kansas begins at $16,000. In neighboring Missouri, you ordinarily pay state income tax on earnings in excess of $1,000. However, couples filing jointly with an adjusted gross income below $32,000 can claim an exemption on 401(k) or pension income. In Nebraska, pension plan exemptions only apply to the military.
State level tax breaks on 401(k) withdrawals are based on the premise that you're a retiree. The federal government regards age 59 1/2 as the official retirement age, while age guidelines vary from state to state. If you cash in a 401(k) before reaching retirement age, you don't benefit from any applicable state level tax exemptions. You have to pay state income tax on the money as well as federal income tax and possibly a 20 percent federal tax penalty.