They Left Illinois for Indiana to Escape the 4.95% Income Tax. Indiana Taxes Every Dollar of Their Pension and 401(k) Withdrawals, and Illinois Never Did
A retired couple crossed the state line expecting to escape Illinois taxes, but their first Indiana return handed them a bill they never saw coming. The reason comes down to one overlooked exemption that Illinois offers and Indiana simply does…
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A retired couple’s first Indiana tax return shows a $3,827 bill. In Illinois, the same retirement income cost them nothing in state tax.
Imagine both spouses are 67 and file jointly. They sold their house in the Chicago suburbs and bought across the state line in Lake County, Indiana, to get away from Illinois’ 4.95% flat income tax. Their 2026 income includes a $50,000 pension, $40,000 in 401(k) withdrawals and $48,000 in combined Social Security.
Illinois never taxed a dollar of that income. Its 4.95% rate hits wages, interest, dividends and capital gains. The money most retired people live on is exempt.
Illinois Subtracts Retirement Income Under 35 ILCS 5/203
Both states start from federal adjusted gross income, the AGI figure defined in Internal Revenue Code Section 62. At the federal level, pension and 401(k) payouts count as ordinary income under IRC Sections 72 and 402(a). IRA withdrawals fall under Section 408(d), and up to 85% of Social Security benefits are taxable under Section 86.
Illinois then takes that income back out. Under 35 ILCS 5/203, residents subtract distributions from qualified employer plans, government pensions and IRAs, plus Social Security. A Loyola law review analysis puts it simply: Illinois “does not tax any part of a distribution from a qualified retirement plan.” For our couple, Illinois income tax on $138,000 of income comes to zero.
Indiana Taxes 401(k) and Pension Dollars Almost From the First Dollar
Indiana Code 6-3-1-3.5 also starts with federal AGI and fully subtracts Social Security. It offers no general deduction for private pensions, 401(k)s or IRAs. The carve-outs are narrow and mostly cover military retirement pay and certain federal civil service annuities.
What’s left is small. Each spouse gets a $1,000 personal exemption plus another $1,000 for being 65 or older. A further $500 exemption applies only if federal AGI is under $40,000, which rules out this couple. Indiana’s 2026 rate is 2.95%, and Lake County adds 1.5%.
| 2026 Indiana Calculation | Amount |
|---|---|
| Pension plus 401(k) withdrawals | $90,000 |
| Less exemptions (2 personal, 2 age-65) | $4,000 |
| Indiana taxable income | $86,000 |
| State tax at 2.95% | $2,537 |
| Lake County tax at 1.5% | $1,290 |
| Total Indiana tax | $3,827 |
| Illinois tax on same income | $0 |
That works out to about $319 a month. Over 10 years at 2026 rates, it adds up to $38,270. Indiana’s rate falls to 2.90% in 2027, which barely dents the bill.
Federal Deductions Never Reach the Indiana Return
The couple’s federal bill is the same in either state. The 2026 standard deduction of $32,200 for joint filers and the senior deduction added by OBBB (the One Big Beautiful Bill Act) apply after AGI. Indiana starts from federal AGI, so neither reduces its tax base.
Where the Move Still Pays Off
On investment income, the move saves very little. On $10,000 of interest and dividends, Lake County residents pay just $50 less than they would in Illinois.
The stronger case is property tax and living costs. The 2025 State Tax Competitiveness Index places Illinois 41st on property tax and Indiana 5th. Bureau of Economic Analysis data for 2024 puts Indiana’s price index at 93.329, versus 99.958 for Illinois.
Three Moves to Make Before Crossing the State Line
- Take big withdrawals and Roth conversions while you’re still an Illinois resident. The state where you live when you receive the money gets to tax it, and federal law (4 U.S.C. 114) bars Illinois from taxing pension income paid to nonresidents. Illinois’ deduction covers Roth IRA conversions, so you’d owe only federal tax on the conversion. Qualified Roth withdrawals later never show up in federal AGI, which puts them out of Indiana’s reach.
- Look up the county rate before you look at houses. Hamilton County charges 1.1% and Marion County charges 2.02%. On $86,000 of taxable retirement income, that gap adds up every year.
- File the move year correctly. You’ll file a part-year Illinois return (IL-1040 with Schedule NR) and Indiana’s Form IT-40PNR. Split your income by the date you established legal residence.
Consider the property-tax savings against the new income-tax bill, and run the conversion timing with a CPA before the moving truck shows up. Those quiet years between your last paycheck and your first RMD may be the cheapest tax window you ever see again, which is the whole subject of our free Roth Window guide.
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Vilma Rios is a tax professional and tax content contributor with more than 15 years of experience in tax and accounting. She specializes in federal tax research, tax education, and translating complex tax rules into clear, practical information for individuals, families, and small-business owners.
Vilma is a Content Tax Contributor II with the National Association of Tax Professionals (NATP), where she contributes to tax education and professional content. She has also presented tax information through webinars, including Spanish-language tax education, and has appeared on Telemundo 47 discussing tax topics and helping viewers understand important tax-filing requirements.
Her experience also includes tax and accounting work, tax research, IRS-related matters, and public tax education. While in college, Vilma volunteered in an IRS-sponsored tax assistance program and was recognized for her community service by local and state officials.
Known as “Your Tax Geek,” Vilma is passionate about making taxes easier to understand and helping people navigate an increasingly complex tax system.
