Retirement Income: What the IRS Taxes and What It Leaves Alone

Not every dollar you receive in retirement is taxed the same way. Some sources are fully taxable, while others receive special treatment or are exempt altogether.

The IRS rules can also influence your Social Security tax bill and Medicare premiums, so it pays to understand how different income streams are classified before planning your finances.

Income that is fully taxable

Wages from full-time, part-time or gig work, including salary, tips and bonuses, are treated as ordinary income and are fully taxable. The same is true for withdrawals from traditional individual retirement accounts (IRAs) and 401(k) plans. That matters especially once required minimum distributions (RMDs) begin, since you must withdraw a set percentage of your portfolio each year after reaching age 73.

Interest earned from bonds, bank accounts or certificates of deposit (CDs) is also generally taxable. One exception is municipal bond interest, which is often exempt from federal tax and may also be exempt from state and local taxes.

Pension payments are usually taxed as ordinary income unless you contributed after-tax money to the plan.

Social Security may be only partly taxable

Up to 85% of Social Security benefits can be subject to federal income tax. If your income is below $25,000 a year, or below $32,000 for married couples filing jointly, those benefits are not federally taxable. If income falls between $25,000 and $34,000, or between $32,000 and $44,000 for married couples, up to 50% of benefits may be taxed. Above those levels, as much as 85% can be taxable.

For this purpose, “combined income” includes adjusted gross income, tax-exempt interest and half of your annual Social Security benefits.

Income that is generally tax-free

Tax-free income can play an important role in retirement planning and help cushion rising expenses. Withdrawals from Roth IRAs and Roth 401(k)s are tax-free because those accounts are funded with after-tax dollars. Those withdrawals also do not affect how much of your Social Security benefits are taxed, and they are not subject to RMDs.

Municipal bond interest may also be tax-advantaged, and life insurance proceeds paid to beneficiaries are typically not taxable. In addition, withdrawals from health savings accounts (HSAs) for qualified medical expenses, gifts you receive and inherited Roth IRA withdrawals are generally tax-free.

Take stock of your income sources

Reviewing your full financial picture can help you see which income streams you have and how much of your Social Security benefits may be taxed. When you list your sources of income, be sure to note the tax treatment of each one.

Careful tax planning can sometimes reduce taxable income and lower the tax owed on Social Security benefits. For instance, a partial Roth conversion before retirement may be useful because withdrawals from Roth accounts are not taxed.