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How to Plan for Income Taxes in Retirement

Dana Anspach

April 18, 2024

Retirees face new challenges planning for taxes in retirement.

While you are likely to have less income than during your peak working years, which implies lower taxes, you’ll likely have multiple sources of income. And that complicates tax payments for those accustomed to a single source from their employer.

Cash flow comes from Social Security, required minimum distributions from retirement accounts, interest, dividends and capital gains from investments, deferred compensation plans, rental property, pensions, annuities, freelance or part-time work, etc.

Note. Instead of getting a single paycheck with tax withholding done by an employer, many retirees need to make quarterly payments or set up their tax withholding directly from their IRA or other retirement account distributions.

Because your sources of income may be more diverse than when you were working, and each source of income comes with a distinct set of tax rules, taxes in retirement may be more complicated than when you were working. Knowing the nuanced rules and planning the timing of withdrawals can help you avoid under-withholding penalties and help lower your lifetime tax bill. With planning, taxes will not catch you off guard, and you can spend your time enjoying your retirement lifestyle.

If you’re approaching retirement, it behooves you to look closely at your future income sources and the taxes you will pay in retirement. Then, you can budget accordingly, plan your withdrawal strategy, and determine if you should set up automated tax withholding or make quarterly tax payments. The prospect of paying quarterly taxes requires a significant shift in thinking for many.

Let’s look at how taxes apply to the different types of retirement income you may receive.

Social Security

When FDR passed the Social Security Act during the Great Depression, Social Security benefits were intended to be a supplement – not a primary source of retirement income. Today, according to the Social Security Administration, Social Security payments replace, on average, approximately 40% of retirees’ pre-retirement wages.

Initially, Social Security payments weren’t subject to taxes. Today, if Social Security is your only source of income, you won’t pay any taxes either.

However, many retirees have additional sources of income. And the taxation of your Social Security benefits is tied to a formula that includes your other sources of income; as your other income goes up, a larger portion of your Social Security benefits become subject to taxation, up to a cap of 85%. This is not an 85% tax rate – it means 85% of the Social Security you receive can be subject to taxation. Or, on the bright side, you’ll receive 15% of your Social Security benefits tax-free no matter what.

If you have IRA withdrawals, a pension, or other sources of income stacked on top of Social Security (SS), then a portion of your SS income is likely to be taxed.

The portion of taxed benefits depends on how much income you have in addition to Social Security. The IRS calls this other income “combined income.” Money from pensions, part-time jobs, 401(k)s, investments, rental income, etc., falls into this bucket. For example, retirees with a high monthly pension income will likely pay taxes on 85% of their Social Security benefits.

Tip. The IRS provides a tax worksheet where you plug your combined income into a formula to determine the portion of your Social Security benefits that are taxed each year. There is also an easy-to-use online Social Security tax calculator you can use to come up with an estimate.

So far, we have been talking about federal taxation. State taxes apply, too. You may live in one of the 40 states (and Washington, DC) (as of 2024) that don’t tax Social Security income, or you may consider moving to one of them – for at least 183 days per year (the “in residence” cut-off) — when the time comes. Keep in mind some states make up for the loss of revenue on income taxes, including those on Social Security benefits, with other taxes, like higher property taxes. Kiplinger offers a great tool to see which states are tax-friendly for retirees.

IRA and 401(k) withdrawals

Once you reach a certain age —73 if you were born between 1951 and 1959; 75 if you were born on or after 1960— you must start withdrawing money from your retirement plan accounts each year. These required distributions must come from ordinary IRAs and 401(k) plans, 403(b) plans, and 457 plans.

The government requires you to take the Required Minimum Distribution (RMD) so it can collect taxes on this income. You will pay taxes on retirement account withdrawals, except for Roth IRA withdrawals. Stiff penalties may apply if you do not withdraw the required amount each year. For example, the IRS imposes a 25% tax penalty on amounts not properly disbursed from your 401(k) or IRA.

The amount of tax you pay on these withdrawals depends on your total income and deductions and what tax bracket you are in for that year. For example, if you have a year with more deductions than income (such as a year with large medical expenses or large business losses), you may pay no tax.

Roth IRA disbursements are not taxed because you did not receive a tax deduction for the contributions to the Roth. Since the contributions were already taxed, they are not taxed again upon withdrawal. The investment income earned inside a Roth is also tax-free as long as you don’t withdraw it before age 59 1/2, and you must have had the Roth account open for at least five years. Roth IRAs do not have required distributions, so you can let the money grow tax-free for your whole life if you want. Then, Roth accounts pass tax-free to your beneficiaries.

Note. Non-spouse Roth IRA beneficiaries must take required distributions from the Roth accounts after inheriting them.

Pensions

Most of the time benefits from pensions and annuities are fully taxed. As with IRAs and 401(k)s, there’s a simple rule of thumb to predict whether you will have to pay taxes in retirement on pension and annuity income. If the money went into the fund – either by you or your employer — before it was taxed, it will be taxed when you withdraw it. Most workers and employers fund pension accounts with pre-tax income, which means it will be taxed when received in retirement. As a convenience, you can have taxes withheld directly from your pension checks.

Note. In the unusual circumstance you funded a portion of your pension account with after-tax dollars, that portion of your benefit will not be taxed upon distribution.

Annuities

An IRA can own annuities. If so, the tax rules that apply to the IRA apply to any annuity withdrawals.

Non-qualified (NQ) annuities are not owned by a retirement account. These NQ annuities were purchased with after-tax dollars, and the growth in the annuity is typically tax deferred. In these cases, the taxation of any distributions depends on the type of annuity you bought. A few examples are below:

  • Immediate Annuities—Payments from an immediate annuity include principal and interest. Only the interest portion is considered taxable income. But, since your length of life is unknown, the portion of each payment considered to be interest is determined by an actuarial formula that considers the expected lifetime payout. This formula results in an exclusion ratio that designates which part of each payment is excluded from taxation (as that portion is a return of principal.)
  • Fixed and Variable Deferred Annuities—When you place money in a fixed or variable deferred annuity (deferred meaning you have not annuitized the contract, or in other words, the income phase will not begin until later), you do not have to pay taxes on the gain in the annuity until you take withdrawals. Like most retirement vehicles that offer tax deferral, if you take money out before age 59½, any gain withdrawn is taxed at your ordinary-income tax rate and is subject to a 10% penalty tax. For a non-qualified deferred annuity (one not owned by an IRA, Roth IRA, or another tax-deferred retirement vehicle), tax-ordering rules dictate that investment gain is withdrawn first and taxed, and basis (or principal) comes out last.

Tip. When your IRA or another retirement account owns an annuity, the tax rules of the parent retirement account will apply to any withdrawals or annuity payments you receive.

Other taxable retirement income

Remember that other income accrued during retirement is also taxed. Interest income, dividends, and capital gains on investments will be taxed just as before you retired. If you plan to sell assets to generate retirement income, each sale will likely cause a long or short-term capital gain or loss, which you report on your tax return.

Tip. if you sell investments outside a retirement account, be intentional with the timing of your capital gains and losses to help manage your tax liability.

Not all retirement income is taxed

You may wonder if every dime you receive during retirement is taxed. The answer is, thankfully, “no.” Not every source of cash flow from investments counts as taxable income. For example, if you own a bank CD that matures in the amount of $10,000, that $10,000 is not taxable income as that is your principal amount coming back to you. However, you would have reported the interest the CD earned each year.

Here are a few potential federal tax-free sources of cash flow in retirement:

  • Roth IRA and Roth 401(k) withdrawals that follow the rules
  • Municipal bond interest
  • HSA withdrawals used for qualified health expenses
  • Certain types of withdrawals (of basis) or loans from cash-value life insurance
  • Return of principal portion of investments
  • Up to $500k of gain from the sale of a primary residence if married, $250k if single (subject to rules such as living there two of the past five years)

How to manage taxes in retirement

Your tax rate in retirement will depend on your total income and your deductions, just as it does while you are working. To estimate the tax rate:

  1. List each type of income and the taxable portion
  2. Estimate deductions and exemptions.
  3. Calculate the difference to estimate taxable income.
  4. Plug that income into current tax tables to see your tax rate and estimated tax liability.

While some folks enjoy doing this by hand, I’d suggest plugging these numbers into an online 1040 tax calculator, which will tell you what your tax rate and total taxes will be.

Everyone’s financial circumstances are different. Paying lower taxes in retirement may be feasible. It takes research or the assistance of a professional retirement planner or tax advisor.

This article introduces tax rules in retirement. To learn more, watch our YouTube recording of our Tax Planning for Retirement webinar.