When Will Retirement Income Be Taxed?
Retirement can change the way your income is taxed—but it doesn't necessarily mean your tax bill disappears.
In fact, one of the most common retirement surprises is realizing that several different sources of retirement income can be taxable, sometimes in ways that aren't obvious when you're saving.
The good news is that taxes in retirement are often something you can plan for. Understanding where your retirement income comes from, when you expect to use it, and how different accounts are taxed can help you make better decisions before you retire.
Not All Retirement Income Is Taxed The Same
The tax treatment of retirement income depends largely on where the money comes from.
Traditional retirement accounts, such as traditional IRAs and many employer-sponsored retirement plans, generally contain money that has not yet been taxed. When you take money from these accounts, the withdrawal is generally included in taxable income.
Roth accounts work differently. Qualified withdrawals from Roth IRAs and Roth retirement accounts can generally be taken tax-free.
Social Security can also be taxable depending on your overall income and circumstances. And income from investments, pensions, annuities, rental property, or part-time work may have their own tax considerations.
That means two retirees with the same amount of annual income could have very different tax situations depending on where their income comes from.
Your Income Sources Work Together
It's easy to look at each source of retirement income separately.
For example, you might think:
- "My Social Security isn't very large."
- "I'll only take what I need from my IRA."
- "My investment income isn't much."
- "My pension is manageable."
But your tax return doesn't necessarily look at those sources in isolation.
The combination matters.
Consider a couple who receives Social Security, a pension, and withdrawals from a traditional IRA. None of those sources may seem particularly concerning by itself. But when combined, the additional IRA withdrawals could increase their taxable income and change the tax treatment of other income.
This is one reason retirement income planning is different from simply asking, "How much money do we need each year?"
You also need to consider how you will create that income.
The Timing Of Withdrawals Matters
When you take money from a retirement account can matter just as much as how much you take.
Suppose you retire at 62 but don't need to withdraw much from your traditional retirement accounts yet. You may have a period when your taxable income is relatively low.
That could create planning opportunities.
Depending on your circumstances, you might consider whether it makes sense to take some income from a traditional retirement account during those lower-income years, convert some funds to a Roth account, or use other sources of cash instead.
The right choice depends on your overall tax situation and long-term plan.
The important point is that you don't have to wait until you need the money to think about how taking it will affect your taxes.
Investments Can Add Taxable Income
Retirement income isn't limited to retirement accounts.
You may also have investments in taxable brokerage accounts. Selling an investment can create a capital gain or loss, while some investments may generate dividends or other taxable income.
For example, imagine you need $40,000 to supplement your retirement income.
You could potentially create that cash flow in several ways:
- Withdraw from a traditional IRA.
- Take money from a Roth account.
- Sell investments in a taxable account.
- Use a combination of accounts.
The amount of cash you receive could be the same, but the tax consequences may be very different.
That's why retirement planning shouldn't stop at determining how much you need to withdraw. The source of the withdrawal matters, too.
Your Tax Picture Can Change Over Time
Your retirement tax situation isn't necessarily fixed.
Your income may change as you move from employment to retirement. Social Security may begin later. A pension may start at a different time. Required distributions from retirement accounts may eventually become part of the picture. You might sell investments, downsize your home, start a business, or return to work.
Each change can affect the overall tax picture.
For example, someone who retires at 60 may have several different financial stages ahead: early retirement before Social Security, Social Security years, later retirement when additional retirement-account distributions begin, and potentially a period when health care or long-term-care costs become more significant.
Planning for only the first year of retirement can miss important opportunities later.
Start With A Retirement Income Map
You don't need to know exactly what your taxes will be twenty years from now.
But you can start by identifying the sources you expect to use.
Make a simple list of:
- Social Security benefits
- Pensions
- Traditional retirement accounts
- Roth retirement accounts
- Taxable investments
- Real estate or rental income
- Business income
- Other expected income
Then consider when each source could begin providing income and how that income is generally taxed.
You can also look at your current tax return and ask a more useful question than, "How much did I pay?"
Ask: "What will change when my paycheck goes away?"
That question can reveal where retirement planning and tax planning need to work together.
Retirement Should Include A Tax Strategy
Retirement isn't just about accumulating enough money. It's also about turning that money into income in a way that supports your goals.
Taxes are one part of that equation.
Before retirement, consider how your different accounts may be taxed, when you expect to use them, and how changes in income could affect your overall situation. A retirement income strategy can help you evaluate those decisions before you're forced to make them.
You don't need to predict every future tax bill.
You do need to recognize that the way you structure retirement income can affect how much of that income you actually get to keep.
That makes taxes worth considering long before the first retirement withdrawal.