Which Retirement Income is Taxable?

As you plan for retirement, it's crucial to understand how your various income sources will be taxed. This knowledge can help you make informed decisions about your savings strategies and withdrawals in retirement.

One of the biggest concerns we’ve heard from clients close to retirement is “How do we plan for taxes?”

If you’re financial advisor is not having in depth discussions about your tax plan for retirement with you, feel free to reach out for a complimentary consultation to discuss your unique circumstances. At Keep It Simple Financial Planning, we’re here to guide you through the tax landscape of retirement income.

Taxable Retirement Income

1. Traditional 401(k) and IRA withdrawals: Contributions to these accounts are typically made with pre-tax dollars, meaning you'll pay income tax on your withdrawals in retirement.

2. Pension income: If your employer funded your pension, the payments you receive in retirement are usually taxable as ordinary income.

3. Annuity payments: The taxable portion of annuity payments depends on whether the annuity was purchased with pre-tax or after-tax funds. If you used pre-tax funds, the entire payment will be taxed as ordinary income. If you used after-tax funds, only the earnings portion of the payment will be taxed.

4. Earned income: If you continue to work part-time or start a small business in retirement, your earned income will be subject to income tax and, potentially, self-employment tax.

Partially Taxable Retirement Income

Social Security benefits: Depending on your total income, up to 85% of your Social Security benefits may be subject to income tax. The specific percentage depends on your "provisional income," which includes your adjusted gross income, nontaxable interest, and half of your Social Security benefits.

Provisional Income and Social Security Taxation

Provisional income, also known as "combined income," is a measure used by the IRS to determine the taxability of your Social Security benefits. It's calculated by adding your adjusted gross income (AGI), nontaxable interest, and half of your Social Security benefits.

The formula for provisional income is:

Provisional Income = AGI + Nontaxable Interest + 1/2 of Social Security Benefits

Single Tax Filers

For single tax filers, the taxation of Social Security benefits is determined as follows:

If your provisional income is less than $25,000, your Social Security benefits are not taxable.

If your provisional income is between $25,000 and $34,000, up to 50% of your Social Security benefits may be taxable.

If your provisional income is more than $34,000, up to 85% of your Social Security benefits may be taxable.

Example: Let's say you're a single tax filer with an AGI of $20,000, nontaxable interest of $2,000, and Social Security benefits of $12,000. Your provisional income would be $20,000 + $2,000 + ($12,000 × 0.5) = $28,000. In this case, up to 50% of your Social Security benefits may be taxable.

Married Couples Filing Jointly (MFJ)

For married couples filing jointly, the taxation of Social Security benefits is determined as follows:

If your provisional income is less than $32,000, your Social Security benefits are not taxable.

If your provisional income is between $32,000 and $44,000, up to 50% of your Social Security benefits may be taxable.

If your provisional income is more than $44,000, up to 85% of your Social Security benefits may be taxable.

Example: Let's say you and your spouse have a combined AGI of $30,000, nontaxable interest of $4,000, and Social Security benefits of $20,000. Your provisional income would be $30,000 + $4,000 + ($20,000 × 0.5) = $44,000. In this case, up to 50% of your Social Security benefits may be taxable.

It's important to note that these thresholds are not indexed for inflation, meaning they do not adjust each year based on changes in the cost of living. As a result, more retirees may find their Social Security benefits subject to taxation over time.

Strategies to Minimize the Taxation of Social Security Benefits

1. Manage your income sources: Be mindful of how much you withdraw from taxable accounts, as this can increase your AGI and, consequently, your provisional income.

2. Utilize Roth accounts: Withdrawals from Roth IRAs and Roth 401(k)s do not count towards your provisional income, as they are generally tax-free.

3. Consider tax-exempt investments: Interest from municipal bonds is not included in your AGI, which can help keep your income below the taxation thresholds.

Tax-Free Retirement Income

1. Roth 401(k) and Roth IRA withdrawals: Contributions to these accounts are made with after-tax dollars. As a result, your withdrawals in retirement are tax-free, provided you meet certain requirements, such as holding the account for at least five years and being over age 59½.

2. Municipal bond interest: Interest earned from municipal bonds is generally exempt from federal income tax and, in some cases, state and local income taxes.

3. Health Savings Account (HSA) withdrawals: If you use HSA funds for qualified medical expenses, the withdrawals are tax-free.

Strategies to Minimize Retirement Income Taxes

1. Diversify your retirement accounts: By having a mix of taxable, tax-deferred, and tax-free income sources, you can better manage your tax liability in retirement.

2. Consider Roth conversions: Converting a portion of your traditional IRA or 401(k) to a Roth account can help reduce your tax burden in retirement, especially if you expect to be in a higher tax bracket.

3. Be mindful of withdrawal order: Generally, it's advantageous to withdraw from taxable accounts first, followed by tax-deferred accounts, and lastly, tax-free accounts. This strategy allows your tax-advantaged accounts more time to grow.

4. Time your income sources like Social Security and Pensions intentionally. By integrating the timing of your income sources with other techniques like Roth conversions, you can increase your lifetime income received and save on taxes.

At Keep It Simple Financial Planning, our team is dedicated to helping you create a retirement income plan that maximizes your savings and minimizes your tax liability. If you have any questions or would like to discuss your specific situation, please don't hesitate to contact us.

Download our Important Numbers Guide to learn more about the different types of taxation you’ll need to be aware of in retirement.