How Are 401k Withdrawals Taxed in Puerto Rico?

Saving for retirement through a 401(k) is a key financial strategy, but understanding how withdrawals are taxed is just as important. If you live in Puerto Rico or plan to retire there, the tax treatment of your withdrawals differs from the U.S. federal system, affecting how much you actually receive.

Puerto Rico has its own tax rules, separate from the IRS, which means different rates, withholding requirements, and penalties apply. Understanding these differences can help you plan effectively and avoid unexpected tax liabilities.

Puerto Rico Tax Rates

401(k) withdrawals in Puerto Rico are taxed under local rates rather than U.S. federal income tax. The tax treatment depends on whether the retirement plan is qualified under Puerto Rico law. If it is, withdrawals are taxed as ordinary income at Puerto Rico’s progressive tax rates, which range from 0% to 33% in 2024.

Retirees with lower taxable income may have part of their withdrawals taxed at the lower brackets, reducing their overall burden. Higher earners could see a significant portion taxed at the top rate. Additionally, Puerto Rico allows a one-time exemption of up to $31,000 for lump-sum distributions from qualified plans and $23,000 for non-qualified plans, making part of a large withdrawal tax-free.

Withdrawals from dual-qualified plans—those that meet both U.S. and Puerto Rico tax codes—may be taxed in both jurisdictions. The taxability depends on how contributions were made, potentially leading to double taxation if not planned carefully.

Withholding and Reporting

401(k) withdrawals in Puerto Rico follow local withholding rules. For lump-sum distributions from a qualified plan, a flat 20% is withheld at the time of withdrawal as an advance payment toward total tax liability. The final amount owed depends on total income and deductions.

For periodic distributions—such as monthly or annual payments—tax withholding follows Puerto Rico’s income tax tables, similar to wage taxation. The payer reports distributions using IRS Form 499R-2/W-2PR, which functions like a U.S. W-2 but follows Puerto Rico’s tax system. The recipient must report this income on their Puerto Rico tax return and pay any additional tax due.

Withdrawals from dual-qualified plans require careful reporting. Depending on how contributions were structured, a portion of the distribution may also need to be reported to the IRS using Form 1099-R. This can require filing tax returns in both Puerto Rico and the U.S., making coordination essential to avoid overpayment or penalties.

Early Withdrawal Penalties

Withdrawing from a 401(k) before retirement age can trigger penalties. In Puerto Rico, withdrawals before age 60 generally incur an additional 10% penalty on top of regular income taxes.

Some exceptions allow individuals to avoid this penalty, though they are more restrictive than under U.S. federal law. Withdrawals due to permanent disability or medical expenses exceeding 7.5% of adjusted gross income may qualify for an exemption. However, distributions for first-time home purchases or higher education expenses—common exceptions under IRS rules—do not receive the same treatment in Puerto Rico and still incur the 10% penalty.

The method of withdrawal also affects penalties. Lump-sum withdrawals are fully subject to the penalty, whereas substantially equal periodic payments (SEPP) may be exempt if they continue for at least five years or until the account holder turns 60, whichever is longer. This can be a strategic way to access funds early without additional costs.

Rollover Provisions

Moving retirement funds between accounts without triggering taxes requires following Puerto Rico’s rollover rules. A rollover from a Puerto Rico-based qualified plan must go into another Puerto Rico-qualified plan or an individual retirement account (IRA) that complies with local tax laws. Rolling funds into a U.S.-only plan may result in a taxable distribution in Puerto Rico, even if no immediate withdrawal occurs.

The timing of the rollover is also important. Puerto Rico follows a 60-day rollover deadline, meaning funds must be deposited into the receiving account within this period to avoid taxation. If the rollover is not completed in time, the entire amount may be subject to ordinary income tax, and if the account holder is under 60, an early withdrawal penalty could also apply.