By Gail R. Hauseman, CPA, and Rodger J. Krause, CPA

One of most disturbing things that can happen to any tax preparer is to have a client notify them they received a letter from the Pennsylvania Department of Revenue proposing an increase in their income tax. Especially after you took so much care to properly prepare the return months ago. Often, these letters are adjustments to taxable income because distributions on 1099-Rs are treated differently on the Pennsylvania return than on the federal tax return. Form 1099-R shows distributions from pensions, annuities, retirement plans, IRAs, and insurance contracts. Pennsylvania does not tax commonly recognized pension, old age, or retirement benefits paid after becoming eligible to retire and retiring. Pennsylvania does not follow federal law concerning certain retirement plans, and specific Pennsylvania rules determine what portion is taxable for Pennsylvania. This blog post summarizes some of the more common rules you need to apply with 1099-Rs.

Eligible Retirement Plans

Pennsylvania does not tax income reported on a 1099-R from an eligible retirement plan. But what is an eligible Pennsylvania retirement plan? The State Employees Retirement System, the Pennsylvania Municipal Employees Retirement System, and the U.S. Civil Service Commission Retirement Disability Plan are eligible plans. None of these distributions are taxable for Pennsylvania tax purposes.

Additionally, these four requirements must be met in an eligible Pennsylvania retirement plan.

• The plan is written and has been communicated to employees.
• The plan establishes eligibility requirements for separation, old age, infirmity, or long-time service.
• The plan provides recurring payments after separation of service until death.
• The plan does not permit distributions until termination of employment, except for disability or the return of employee previously tax contributions.

Gross Distributions

Box 1 on the 1099-R (Gross Distribution) is taxable unless the distribution is from a Pennsylvania-eligible plan or you retired after meeting the age conditions or years of service conditions of the plan. If this distribution is taxable, you may use the cost recovery method to determine the taxable portion. (All prior employee contributions are tax-free and are considered before employer contributions and investment appreciation.)

Box 7 Codes

The federal codes in Box 7 of Form 1099-R may help indicate the taxability of a distribution:

• Code 1 or 2 (Early Distribution) is generally taxable for Pennsylvania purposes unless it was an eligible plan and you retired after meeting the plan age requirement or years of service requirement.
• Code 3 or 4 (Death/Disability) is not taxable for Pennsylvania tax purposes.
• Code 5 (Prohibited Transaction) is generally taxable.
• Code 7 (Normal Distribution) is not taxable if retired after meeting the plan retirement age and/or years of service. For a Code D, see annuities below.
• Code 8 (Excess Contributions) is taxable to the extent there are excess earnings, or the employer did not include the contributions as taxable compensation.
• Code G or H (Rollover) is not taxable for Pennsylvania tax purposes.

Annuities, Life Insurance, and IRAs

Investment in an annuity that is not an employer-sponsored retirement plan may have Pennsylvania taxable income when withdrawal on the annuity begins, regardless of age. The same applies for life insurance contracts. If there is an amount indicated as taxable for federal income tax purposes (often this is Box 2 on Form 1099-R, and the Box 7 code is 7D), you are required to report the amount in Box 2 as interest income for personal income tax purposes.

Amounts withdrawn from an IRA are includable in income to the extent that contributions and income earned on such contributions were not taxed previously, except distributions made on or after reaching the age of 59 1/2. IRA disability payments are taxable on a cost-recovery basis if you are not 59 1/2 years old. Traditional IRA rollovers (100%) to another traditional IRA are not taxable. There are special rules for Roth IRA rollovers.

The above summarizes some of the more common rules for the Pennsylvania taxation of 1099-R income. For a more detailed analysis, see the Personal Income Tax Preparation Guide from the Pennsylvania Department of Revenue. 

Gail R. Hauseman, CPA, is owner of Berkshire CPAs LLC in Wyomissing, Pa. She can be reached at berkshirecpas@gmail.com.

Rodger J. Krause, CPA, is a sole practitioner with Rodger Krause CPA Inc. in Wyomissing. He can be reached at rkrause@rodgerkrausecpa.com.

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