How Is Your Retirement Income Taxed?

Retirement is a time when you should be enjoying the fruits of your labor. But did you know that your retirement income may be taxed? Understanding how your retirement income is taxed is often more complicated than many people realize, but it is essential to planning your finances for your golden years. Keep reading to learn more about how retirement income is taxed, and which factors may impact the amount you pay in taxes during your retirement.

Sources of Retirement Income

One of the main factors that makes retirement income taxes confusing is the fact that most retirees have several income sources. You may have a pension from your job, 401(k)s, various IRAs, and any number of investments that are all providing you with simultaneous income. The trouble is, each of these income sources can be taxed differently, with some not being taxed at all. Here are some of the most common types of retirement income, and a few key points about how they’re taxed:

• Social Security: Social Security benefits are taxable at the federal level, depending on your income. If your income is below a certain threshold, you won't owe any federal income taxes on your Social Security benefits.
• Pensions: If you receive a pension from your employer, it is generally taxed as ordinary income. However, if you made after-tax contributions to your pension, you won't pay taxes on that portion of your pension.
• 401(k)s and IRAs: Withdrawals from 401(k)s and IRAs are generally taxed as ordinary income. However, if you made after-tax contributions to these accounts, you won't pay taxes on that portion of your withdrawals. This is generally the case with Roth IRA accounts. (More on that below.)
• Annuities: Annuity payments are generally taxed as ordinary income. However, if you purchased an annuity with after-tax dollars, you won't pay taxes on that portion of your annuity payments.

As you can see, the taxation rules for various retirement income sources are far from straightforward. This further muddies the waters when trying to determine how much you’ll pay in taxes during retirement.

Understanding Marginal Tax Rates

The tax you pay on your retirement income is based on your marginal tax rate. Your marginal tax rate is the rate at which the last dollar you earned is taxed. The federal government has seven tax brackets, ranging from 10% to 37%, based on your income level.

For example, let's say your taxable income is $50,000, which puts you in the 22% tax bracket. If you withdraw $10,000 from your 401(k), that $10,000 would be taxed at 22%, meaning you would owe $2,200 in federal income taxes on that withdrawal.

State Income Taxes

In addition to federal income taxes, you may also owe state income taxes on your retirement income. Each state has its own rules for taxing retirement income, so it's essential to research your state's laws. Some states don't tax retirement income at all, while others tax it at the same rate as ordinary income.

Taxation of Social Security Benefits

We mentioned Social Security income above, but let’s dig a little deeper into how your income level impacts the taxes on this income source. Social Security benefits are taxed at the federal level if your combined income exceeds a certain threshold. Your combined income is calculated by taking your adjusted gross income and adding back in any tax-exempt interest income and half of your Social Security benefits.

If your combined income is:

• Below $25,000 (single) or $32,000 (married filing jointly), your Social Security benefits won't be taxed.
• Between $25,000 and $34,000 (single) or $32,000 and $44,000 (married filing jointly), up to 50% of your Social Security benefits may be taxed.
• Above $34,000 (single) or $44,000 (married filing jointly), up to 85% of your Social Security benefits may be taxed.

Note that those percentages above are not the amount you pay in tax. So, you will not have to pay back 85% of your Social Security income if you make over $34,000 and you’re single. Rather, 85% of that income will be subject to your income tax bracket, while the remaining 15% will not be taxed at all.

Taxation of Roth IRA Withdrawals

Roth IRAs are unique in that you contribute after-tax dollars to the account, meaning you won't pay taxes on your withdrawals in retirement. However, there are some rules to follow.

First, you must have held the account for at least five years to qualify for tax-free withdrawals. Second, you must be at least 59 1/2 years old to withdraw funds without penalty. If you withdraw funds from your Roth IRA before age 59 1/2, you may owe taxes and penalties.

Get Help Understanding Your Retirement Income Taxes

Far too many retirees find themselves facing large, unexpected tax bills, simply because they don’t understand how their retirement income is taxed. We encourage you to reach out to Peacock & French, CPAs, today to speak to one of our experience tax professionals so that you can better understand your taxes and plan for your finances during your retirement years.