Navigating retirement taxes can be challenging. Your tax situation may be different during your working years due to changes in income and tax brackets. Required withdrawals from retirement accounts and income from other sources can also affect your tax liabilities.
That’s why it’s important to know how common sources of retirement income are taxed. Having this information will help you create an efficient tax strategy for your retirement years.
Also in Kiplinger: Tax Season Is Here: Seven IRS Changes to Know Before You File
Subscribe to Kiplinger’s Personal Finance
Be a smarter, smarter investor.
Save up to 74%
Is retirement income taxable?
Comprehensive retirement planning involves considering various sources of income and understanding how they are taxed at the federal and state levels. But thankfully, not all income is considered taxable income. For example, life insurance proceeds, long-term care insurance payments, disability benefits, muni bond interest, and alimony and child support are generally not taxable. Additionally, income earned in states that do not have an income tax is not subject to taxation at the state level.
However, your tax planning should consider the tax treatment of income from annuities, pensions, Social Security benefits, and retirement savings accounts. You will also want to check the tax liability from various investments, income, and earnings.
Here’s a breakdown of some common sources of retirement income and a brief description of their federal tax implications. (Plus below the state tax on retirement income.)
Social Security Benefits: Depending on temporary income, up to 85% of Social Security benefits can be taxed at ordinary income tax.
Pension: Pension payments are usually fully taxed as ordinary income unless you make after-tax contributions.
Interest Bearing Accounts: Interest payments are taxed at ordinary income rates, but municipal bond interest is exempt from federal taxes and may be exempt from state taxes.
Trading in Stocks, Bonds, and Mutual Funds: Long-term gains (held for one year) are taxed at 0%, 15%, or 20% capital gains tax rates, based on income thresholds. The net investment income tax (NIIT) causes some taxpayers. at a rate of 3.8%.
Dividends: Qualified dividends are taxed at long-term capital gains rates; Non-qualified dividends are taxed as ordinary income based on your federal tax bracket.
Traditional IRAs and 401(k)s: Contributions to traditional IRAs and 401(k)s can reduce your taxable income. However, withdrawals are taxed at ordinary income rates. Required minimum distributions (RMDs) begin at age 73. Withdrawals before age 59 ½ are subject to a tax penalty.
Roth IRAs and Roth 401(k): Contributions to Roth accounts are not tax deductible. However, withdrawals after five years after the initial contribution are tax-free for Roth IRAs, including gains. Withdrawals before age 59 ½ are subject to a tax penalty.
Life Insurance Benefits: Life insurance proceeds are generally not subject to tax when received as a beneficiary. However, surrendering a policy for cash can have tax implications.
Savings Bonds: Bond interest is generally taxable at ordinary income rates upon maturity or redemption but may be tax-free for educational expenses if certain conditions are met.
Annuities: For annuities, the portion representing the principal is tax-free; earnings are taxed at ordinary income rates unless purchased with pre-tax funds.
Selling the House: Primary home sale gains up to $250,000 ($500,000 for married couples) are exempt from income tax if certain ownership and use criteria are met.
State retirement taxes
Creating an efficient retirement strategy requires careful consideration of various sources of income and their tax implications.
- Seek professional guidance if you need help making decisions that will maximize your retirement funds and minimize tax burdens.
Also, note that while this article focuses on federal taxes on different types of retirement income, it’s important to consider the impact of state and local taxes on your finances. To learn more about how all 50 states and the District of Columbia tax retirement, see Kiplinger’s report on Retirement Taxes.