Retirement Income Taxes: What to Know

Upon entering retirement, you may begin to gain access to funds and benefits you’ve built for a long time. Depending on how you’ve saved and invested during your career, you might be able to draw income from various sources, allowing you to match or even surpass what you made while working. However, this may mean you’ll face a much different tax situation than in the past.

Taxes are an important aspect to consider as you’re putting together a comprehensive retirement plan. In this article, you’ll learn what sources of income you can expect to be taxed and effective ways to manage—or even minimize—the taxes you pay in retirement. We’ll also outline the valuable role a financial advisor can play in ensuring you’re prepared.

How Income is Taxed in Retirement

Retirement income may come from various places, depending on your saving strategies. In most cases, however, you’ll face some income tax—federal, state, or both—on the funds from retirement accounts or pensions, benefits such as Social Security, and selling off investments. This can impact the amount of money you get to keep for your retirement and, therefore, must play an integral role in your overarching income plan.

Below is a breakdown of potentially taxable income in retirement:

Social Security Benefits

Social Security can be a primary part of many retirees’ income plans. It can be a supplementary piece of a larger plan, but it could also represent all the monthly income you could take home in retirement. When receiving your benefits, however, you may need to pay taxes, which could directly influence the amount you can take home.

“Approximately 40% of recipients of Social Security benefits are liable for federal income taxes on their Social Security benefits,” says John Accursio, tax attorney at Abrams Garfinkel Margolis Bergson, LLP. “Single taxpayers are taxed up to 50% of their Social Security benefits if their taxable income is between $25,000 and $34,000, and up to 85% if taxable income exceeds $34,000. For joint return taxpayers, up to 50% of their Social Security benefits are taxed if their combined taxable income is between $32,000 and $44,000 and up to 85% if their combined taxable income exceeds $44,000.”

Here is a table illustrating tax rates on Social Security income:

Filing Status	Combined Income	Taxable Portion
Single	$25,000 – $34,000	Up to 50%
Married (Joint)	$32,000 – $44,000	Up to 50%
Single	Over $34,000	Up to 85%
Married (Joint)	Over $44,000	Up to 85%

“It feels unfair that Social Security is taxed, but it is and it’s very hard to avoid,” says Christine Mueller Coley, CFP^®, CDFA^®, Wealth Advisor at SteelPeak Wealth Management. “The number one way to avoid taxes on Social Security is to have very low overall income and by ‘low’, we are talking less than $25,000 in annual income for individuals or less than $32,000 in annual income for married couples to avoid Federal taxes on Social Security,” she adds.

Traditional Retirement Accounts

Like Social Security, tax-deferred traditional retirement accounts can be pivotal in your income strategy when you exit your career. This is because they allow you to reap the gains of compound interest and investing returns you might have earned over the years. But when you become eligible to withdraw money from these accounts, this will be “considered taxable income” at the state (if applicable) and federal levels and, therefore, “taxed at ordinary income rates,” explains Accursio.

Examples of traditional retirement vehicles subject to income tax may include:

• 401(k)s
• 403(b)s
• 457(b)s
• Individual Retirement Accounts (IRAs)
• SEP IRAs
• SIMPLE IRAs
• Health Savings Accounts (HSAs)

Pensions and Annuities

Income from pensions, another common part of a retirement income makeup, is also subject to taxes. “Pension payments are generally considered taxable income unless the taxpayer-funded the pension with after-tax contributions,” says Accursio. As with retirement accounts, the amount you’ll need to pay will vary depending on where you live and the size of your payments.

Similarly, payments from fixed-income vehicles such as annuities are also taxed. However, not unlike your pension, this can vary depending on the tax status of the funds that went into the annuity.

“Annuity payments are considered taxable income if the annuity was purchased with pre-tax funds,” Accursio points out. On the other hand, he says that “payments purchased with after-tax funds that are considered the principal are not considered taxable income.”

Other Sources of Income

While Social Security, retirement accounts, and fixed-income vehicles are typical sources of taxable income you may use, they’re not the only ones to keep in mind. There are many other potential streams of income you may be able to draw from—and it’s critical to consider the taxes you may owe from them.

For example, you might face taxes on any returns you earn from your investment portfolio. This includes taxes on capital gains or dividends from stocks or mutual funds in a brokerage account. Per Accursio, you could also pay taxes on interest income, unless classified as tax-exempt. “Interest income from Treasury bills, notes, and bonds is subject to federal income tax but not state and local income tax,” he adds.

You may also face capital gains tax when you sell an asset in retirement, such as a home or alternative investment, that has appreciated. How might this differ from standard income tax? According to Accursio, “Short-term capital gain, the gain from the sale of an asset held for less than a year, is taxed at ordinary income rates, and long-term capital gain, the gain from an asset held for at least a year, is taxed at capital gain tax rates (0% to 20% depending on total taxable income).”

Finally, any supplemental income you earn as a retiree may incur taxation. This could include money from another job you’ve taken to fill your time, rental properties you own, or more.

Where You Live Matters

As mentioned, taxes on retirement income can have a potentially draining effect on the amount of money you get to enjoy in your golden years. However, this can be even more magnified if you live somewhere with a state income tax. While federal taxes are a constant regardless of location, a state tax can hinder your cash flow in retirement and further delay your withdrawal strategy from tax-deferred accounts such as 401(k)s or IRAs.

“Some states are more friendly to retirees than others,” says Coley, noting that “one obvious option is to look for states that do not have State Personal Income taxes.” However, these states may use other methods to offset the difference, including imposing higher sales and property taxes.

The following nine states currently don’t have an income tax:

• Alaska
• Florida
• Nevada
• New Hampshire
• South Dakota
• Tennessee
• Texas
• Washington
• Wyoming

As Coley highlighted, moving to one of the above is an option if you live in a state with an income tax. The reality, however, is that an interstate move can be challenging, especially if you’re deeply rooted in your community. Many factors may ultimately inform your retirement location, including proximity to family and friends, cost of living, weather, and activities.

Strategies to Manage Taxes

While taxes are certain in retirement—dependent on the volume and type of income—you can use various strategies to manage and possibly minimize them. For example, optimization tactics like tax diversification, utilizing required minimum distributions (RMDs), and Roth conversions can be effective.

Here are some methods of managing taxes in retirement:

Tax Diversification and Strategic Withdrawals

Employing tax diversification, which involves using various accounts with different tax treatments, can help you intentionally plan for taxes on retirement income. Under this strategy, for instance, you may have a combination of taxable, tax-deferred, and tax-free accounts you’ve contributed to over the years. Then, once retirement arrives, you can be more flexible in your withdrawals, perhaps taking from accounts with better tax treatment, such as Roth-designated accounts, first to reduce your liability.

Using Roth Accounts and Conversions

Unlike traditional retirement accounts, Roth-designated vehicles—including Roth IRAs and Roth 401(k)s—let you put in after-tax dollars and withdraw your savings and returns on interest and investments tax-free when you turn 59.5 years old. Because of this, Coley says, “they are a fantastic option for retirement savings.”

You can also explore the option of a Roth conversion, especially if you “don’t currently have a Roth IRA,” suggests Coley. Doing so “takes funds from a pre-tax retirement account and moves them to a Roth Account for tax free growth opportunities,” she says, recommending to “keep in mind you will owe the income tax on the conversion amount in the year you do the conversion.”

Utilizing Required Minimum Distributions (RMDs)

If you’re able, taking advantage of RMDs is another way to manage your taxable income in retirement. In short, this refers to the age when you must begin taking specified amounts of money out of traditional accounts such as 401(k)s, IRAs, SEP IRAs, and SIMPLE IRAs. This presently occurs once you reach 73 years old.

How can you use RMDs to manage taxes? “If you can, you would want to delay taking money out of pre-taxed funds until you are required to with required minimum distributions (RMDs),” explains Steve Azoury, ChFC^®, owner of Azoury Financial in Troy, Michigan. For example, this would be beneficial if you’ve diversified tax-advantaged accounts and have tax-free accounts to withdraw funds from first, combined with Social Security.

Bottom Line and How a Financial Advisor Can Help

As they are throughout your career, taxes are something to not overlook in retirement. But because there are multiple sources of income you could potentially deal with—ranging from retirement accounts, Social Security, and other cash streams—it can be especially nuanced and take a deliberate and careful approach to plan for and manage.

Simply put, it can be complex to properly implement tax management strategies alone. If you’re hoping to put together a comprehensive plan for handling taxes in retirement, consider doing so with the help of an experienced financial advisor or tax planning professional. Azoury warns that “mistakes could cost you thousands before and after retirement starts,” and therefore, “[a] good tax person” or financial advisor “is worth their weight in gold, no pun intended.”

If you’re looking for a professional, prioritize experts who follow a fiduciary duty, as these must put your needs first and avoid conflicts of interest. Also, ensure and have experience working around retirement income and taxes. Here are some common credentials to consider:

• Certified Financial Planner (CFP)
• Chartered Financial Analyst (CFA)
• Chartered Financial Consultant (ChFC)
• Chartered Retirement Planning Counselor (CRPC)
• Retirement Income Certified Professional (RICP)

To find a skilled and reputable financial advisor, you can use this free matching tool. After answering a few questions about your needs, goals, and circumstances, it will connect you with a professional near you.