Understanding the Tax Treatment of Your Retirement Income

Earning income in retirement looks much different than what you were used to during your working years. No longer will you be working in exchange for a paycheck each month, with taxes automatically withheld. Instead, your income will likely come from a variety of accounts and sources—all of which can have different tax implications.  

These potential sources of retirement cash flow—including 401(k)s, IRAs, Roth accounts, brokerage accounts, annuities, Social Security, pensions, part-time earned income, and real estate income—are all taxed differently. Understanding their tax treatments is crucial to prepare for your tax bills each April and to determine the optimal withdrawal strategy. This strategy should aim to maximize investment returns and minimize taxes over your lifetime, rather than focusing solely on a single year’s tax bill, which can sometimes become the default goal. 

How Your Retirement Income Is Taxed 

Your income in retirement will fall into one of three buckets, and there are pros and cons to each: 

Tax-deferred: Your 401(k), 403(b), TSP, and/or IRA is considered a tax-deferred retirement account. These accounts enable you to deduct the contributions from your taxes while anything earned in the account grows tax-free as well. You are only responsible for paying tax once you take withdrawals (typically in retirement). 

Keep in mind your tax-deferred accounts may be subject to required minimum distributions (RMDs) since the IRS wants its share sooner rather than later—meaning you can’t hold onto the money tax-free forever.  

Tax-free: Some of your retirement income will be tax-free, meaning it won’t increase your taxable income when distributions are taken. You’ll typically enjoy tax-free retirement income from Roth accounts (either Roth IRAs or Roth 401(k)s) or from municipal bonds (though in some cases, these may be taxed at the state or local level). 

Taxable: All other forms of income will fall under the taxable bucket, subject to either ordinary income tax or capital gains tax. This includes withdrawals from your brokerage accounts, pension payments, qualified annuity withdrawals, etc. 

It’s important to have income from every bucket to access at different times during retirement. If you plan on retiring early, for example, you may need to rely on your taxable brokerage account until you can withdraw from your 401(k) or IRA without penalty.  

You and your financial advisor can also work together to minimize your tax bill both on an annual basis and across your lifetime by strategically combining income from the various tax buckets. 

Are Social Security Benefits Taxed? 

Yes, your Social Security benefits may be subject to income tax—but the rules are different from other sources of income. 

First, you’ll be responsible for paying taxes on a portion of your Social Security benefits, which maxes out at 85%. The exact amount will depend on your “combined income” and filing status. 

You can determine your “combined income” using the following calculation: 

Your adjusted gross income + nontaxable interest + 50% of your Social Security benefits 

If your combined income falls below $25,000 (or $32,000 for joint filers), you will not need to pay taxes on your Social Security benefits. 

If it falls between $25,000 and $34,000 (or $32,000 and $44,000), you may have to pay taxes on up to 50% of your benefits. 

If it exceeds $32,000 (or $44,000), you may owe taxes on up to 85% of your benefits.  

Keep in mind that some states tax Social Security benefits at the state level as well, though some will offer deductions or credits to help minimize the impact. 

Do Retirees Have to File Taxes? 

If your taxable income exceeds the annual standard deduction amount, you are typically required to file a return. In most cases, even if you earn under the income threshold for filing your taxes, you’ll still want to consider filing annually anyway because you may be eligible for refundable tax credits or returns. 

If you’re 65 and older, ask your tax professional if you qualify for the Schedule R tax credit for the elderly or disabled, which differs a dollar-for-dollar reduction in retirees’ tax bills (if certain requirements are met) 

Need Help Navigating Your Income in Retirement? 

Considering you’ve set aside savings for decades to fund the retirement of your dreams, it’s important to be aware of how that income may be taxed—and what you can do to minimize your tax bill and preserve your wealth. 

At Opal Wealth Advisors, we can help you develop a tax-focused withdrawal strategy for achieving your retirement goals in an efficient and sustainable way.  Bring in your tax return for a complimentary tax assessment to help you get tax-optimized.
Contact us today to learn more.