When you’re planning for retirement, you need to take taxes into account. Whether or not your retirement income is taxable depends on where your retirement income comes from and how much you’ll have. Income taxes after retirement will likely be one of your largest expenses. Planning for taxes after retirement and knowing what or if you owe anything is the best way to avoid financial stress down the road.
The most well-known types of retirement income are either taxable, partially taxable, or tax-free. Here is what you can expect to pay taxes on.
Taxable Retirement Income
Income from traditional retirement accounts is taxed at your regular income tax rate. These types of retirement income are taxed as ordinary income:
- Retirement plan withdrawals: Traditional IRAs, SEPs, 401(k)s, 403(b)s, and similar types of retirement plans are funded with pre-tax dollars either from an employer or individual contributions. Withdrawals from these accounts are subject to taxation.
- Annuity withdrawals: Any gain withdrawn from a fixed or variable annuity (not owned by a retirement account) is taxed as ordinary income.
- Pension income: Pensions are taxable at the regular rate from pension annuities and periodic payments; however, some military and disability pensions may be partially taxable or tax-free. A lump-sum payout means the total tax is due for the same year you file your return. A tip to keep in mind is that rules regarding pension income taxation vary by state. Some states don’t tax pension payments.
- Investment income: You pay tax on most types of investment income as it’s earned. Capital gains that fall into the 0% tax bracket are tax-free.
Partially Taxable Retirement Income
These sources of retirement income are partially taxable:
- Social Security: While 0% to 85% of your Social Security income is taxable, 15% is always tax-free. How much is taxable depends on your income and tax filing status.
- Income from an immediate annuity purchased with after-tax funds: When an immediate annuity is purchased with after-tax money, a portion received is interest and a portion is a return on principal. The interest portion is taxable and if the immediate annuity was bought with pre-tax money, all income is taxable.
- Nondeductible IRA withdrawals: Nondeductible IRAs include some after-tax money, although the IRS collects taxes on the portion that came from the income and gains that the nondeductible IRA contribution generated.
- Cash-value life insurance policy: If the cash value exceeds the cost basis when the policy is cashed in, then that portion is taxable.
Tax-Free Retirement Income
Here are tax-free sources of retirement income:
- Roth IRA withdrawals: Roth IRA contributions are made with after-tax dollars. Withdrawals from a Roth IRA are tax-free if:
- You withdraw no more than the amount of your original contributions
- You are 59½ or older, and you’ve had the Roth IRA account for five years or longer
- You’re under 59½, but you’re taking distributions due to a disability
- Municipal bonds: Income from municipal bonds is generally free from federal income taxes but may be subject to state taxes.
- Reverse mortgage: Monthly payments or a lump-sum payment from a reverse mortgage is tax-free.
- Return of principal or cost basis: Withdrawals of cost basis are not taxable once all gain has been withdrawn from an annuity.
- Gain from sale of a home: If the gain from the sale of a primary residence is less than $250,000 for single filers and $500,000 for married and the home was lived in for at least two of the last five years, then this meets the IRS requirements for tax exclusion.
Start Planning for Taxes Before Retirement
When you start to plan for retirement, you need to take income taxes into consideration. The last thing you want is a big, unexpected tax bill when you retire and rely on a fixed income. For additional information, the IRS provides a Tax Guide for Seniors in Publication 554 to help retirement planners better prepare.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Realized does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.
