Taxes in retirement

Financial Planning | Retirement

A key part of planning for retirement is determining how much income you’ll need to meet your expenses in the years after you’ve finished working.

One expense that can’t be overlooked is the impact of taxes on your retirement income.

The tax realities of retirement

Taxes are a given during your working years, because income and payroll taxes are typically withheld from each paycheck. In retirement, however, your “paycheck” is created from a variety of income sources, and you’re responsible for making sure the appropriate taxes are paid.

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 in 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 if, for instance, you no longer carry a mortgage.

Failure to account for taxes on your income could derail your plans. Preparing for them in advance can have a significant impact on how long your assets last in retirement.

Taxes and retirement income sources

The following are common sources of income in retirement and how they may be taxed.

Social Security

A large portion of Americans will likely owe tax on their Social Security benefits. If you are single with “provisional income1” 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.

Annuity payments

Annuity income is at least partially taxable and, in some cases, may be fully taxable. If contributions are made with pre-tax income, then annuity distributions are taxable at ordinary income tax rates. If contributions come from after-tax money, only the portion of distributions representing earnings generated by the account are subject to tax.

Tax qualified pensions

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

401(k)/403(b) distributions

If all contributions to the plan were made with pre-tax dollars, the full amount of the distribution is subject to tax at ordinary income tax rates.2 A direct rollover from a 401(k) or other workplace plans to an IRA can occur without any immediate tax consequences. This typically occurs upon retirement or when you leave an employer, but in certain cases can occur if you are still a participant in the plan.

IRA distributions2

Taxation of IRA distributions depends on the type of IRA from which you are drawing money:

  • Tax-deductible IRAs – all distributions are subject to tax at ordinary income tax rates.
  • Non-deductible IRAs – the portion of distributions attributable to contributions is not taxable, but the portion of distributions attributable to earnings is taxed at ordinary income tax rates.
  • Roth IRAs – if holding period requirements are met, all distributions from Roth IRAs are tax-free.

Life insurance cash values

Cash surrender values of your life insurance policy can generally be accessed tax-free by first withdrawing the cumulative premiums you paid. The remaining cash value can be accessed on a tax-free basis by using it as collateral to obtain a policy loan.

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.

Preparing for taxes well in advance can have a significant impact on how long your assets last in retirement.

Other taxes

Other types of taxes may apply in retirement. These include:

  • Taxes on capital gains and dividends. The most favorable rates apply to long-term capital gains (assets sold after being held at least 12 months) and qualified dividends (those paid by U.S. corporations, some mutual funds and real estate investment trusts).
  • A Medicare surtax of 3.8 percent on the lesser of net investment income or adjusted gross income (AGI) in excess of $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.

Deductions and exemptions

All tax laws related to deductions and exemptions apply in retirement just as they do during your working years. The Tax Cuts and Jobs Act (TCJA) made changes that limited some deductions, such as for a home mortgage or state and local taxes.

The personal exemption that existed under past law is no longer available, but the standard deduction increased to $12,200 for individuals and $24,400 for married couples filing a joint return.

Managing taxes in retirement

One way to manage the impact of taxes 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 percent Medicare surtax.

A standard rule of thumb is to 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 income that is already taxed, such as dividends, and sell assets that qualify for the more favorable long-term capital gains tax rate. After that, consider distributions from tax-deferred accounts such as workplace plans and IRAs.

Read about 3 common retirement withdrawal strategies

Planning today can set you up for a secure future

Tax planning can make a big difference in your retirement income strategy and should be taken into account even if you are years from retirement. Be sure to consult with a tax professional about your own specific circumstances and potential tax ramifications of the financial decisions you make.


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