Taxes in retirement: How income sources are taxed

A key part of planning for retirement is determining how much income you’ll need to meet your expenses, including understanding your taxable retirement income. Your income during retirement will likely come from a variety of sources, and you’re responsible for making sure the appropriate income taxes are paid.

Taxes and retirement income sources

Many people assume that their tax rate in retirement will be lower than it is pre-retirement. This isn’t always true; if you’ve accumulated significant savings for retirement, you may find that your cash flow from all income sources exceeds your earnings during your working years.

You may also have fewer deductions to reduce your tax burden; for example, if you no longer carry a mortgage, that deduction will be eliminated. Additionally, the Tax Cut and Jobs Act eliminated or severely reduced many tax deductions, including those related to state and local income taxes, and increased medical expense deductibility to a higher percent of income. 

Failure to account for taxes on your retirement income could derail your plans. Preparing for them in advance can have a significant impact on how long your assets last in retirement. Following are common sources of income in retirement and their tax implications.

401(k)/403(b) distributions¹

If all contributions to your employer retirement plan were made with pre-tax dollars (which is typically the case), the full amount of the distribution will be taxed at your ordinary income tax rate.

Required minimum distributions (RMDs) must be taken annually beginning at age 73. If you’re still working past the age of 73, you can generally delay RMDs until after you retire.

You can rollover a 401(k) or other employer retirement plan to an IRA without any immediate tax consequences.² This typically occurs when you retire or leave an employer, but in certain cases can occur if you’re still a participant in the plan.

IRA distributions¹

The tax impact of IRA distributions during retirement is determined by the type of IRA you own and whether it was funded with pre-tax or after-tax dollars.

• Traditional IRAs – contributions are considered pre-tax, and all distributions are subject to tax at your ordinary income tax rate.
• Roth IRAs – contributions are considered after-tax, and distributions are tax-free if holding period requirements of at least five years are met.
• Rollover IRAs – assuming all contributions to your workplace retirement plan were made with pre-tax dollars, distributions are taxed at your ordinary income tax rate.

Social Security

A large portion of Americans will likely owe taxes during retirement on their Social Security benefits. If you’re single with “provisional income” above $25,000 or married-filing-jointly with provisional income above $32,000, some or most of your Social Security benefits will be subject to tax.³ Use this online tool from the IRS to determine how much of your benefits are taxable.

Annuities

Annuity income is at least partially taxable and, in some cases, may be fully taxable.

• If contributions were made with pre-tax dollars, then annuity distributions are taxable at your ordinary income tax rate.
• If contributions were made with after-tax dollars, only the portion of distributions representing earnings generated by the account are subject to tax.

Pensions

Since most pensions are funded with pre-tax dollars, your income would be taxed at your ordinary income rate.

Capital gains and dividends

Fully taxable investment vehicles and accounts, such as stock, bonds, and mutual funds are taxed the same whether you’re retired or still employed. Read more about the impact of taxes on investment returns.

Life insurance cash values

Cash surrender values of your life insurance policy can generally be accessed tax-free by first withdrawing the premiums you paid. The remaining cash value can be accessed on a tax-free basis by treating them as loans.

Keep in mind that tapping into a policy’s cash value may reduce the available death benefit. In addition, if the policy loan plus cumulative loan interest ever exceeds the remaining policy cash value, the policy will lapse, resulting in no life insurance protection and a likely income tax surprise.

Medicare surtax

While not directly a retirement income tax, there is a Medicare surtax of 3.8% on the lesser of net investment income or adjusted gross income (AGI) more than $200,000 for single tax filers and $250,000 for married couples filing a joint return. The surtax applies to dividends, capital gains, taxable interest, annuities, rents, and royalties.

Distributions from IRAs and qualified workplace retirement plans are not subject to the Medicare surtax.

Managing taxes in retirement

One way to manage the impact of retirement income tax is to keep your income at a level that places you in the lowest possible tax bracket and avoids being subject to the 3.8% Medicare surtax.

Along with trying to reduce your taxable income in general, consider using these guidelines to help you plan your retirement income:

• Typically, take withdrawals first from taxable accounts, allowing assets in tax-deferred retirement accounts to continue to build in a tax-advantaged way.
• Another priority is to spend down income that’s already taxed, such as dividends, and sell assets that qualify for the more favorable long-term capital gains tax rate, such as stocks and mutual funds.
• After that, consider distributions from tax-deferred accounts such as employer plans and IRAs.

Planning for retirement and taxes can help secure your future

Tax planning can make a big difference in your retirement income strategy and should be considered even if you’re years from retirement. Consult with a tax professional about your own specific circumstances and potential tax implications of the financial decisions you make, and work with a financial professional to integrate a tax strategy into your financial plan.

Learn how we can help you prepare a retirement income strategy.