Retirement Income Sources and How They’re Taxed

Retirement Income Sources and How They’re Taxed

Retirement Income Sources and How They're Taxed

Many people assume their tax burden will decrease in retirement, but that’s not always the case. In fact, taxes can affect your income, especially if you don’t plan ahead. This is because retirement income can come from multiple sources—each with its own tax treatment. Let’s break those down.

1. Social Security Benefits

While Social Security may seem like “free” retirement income, up to 85% of your benefits can be taxed depending on your total income. If your combined income (which includes wages, self-employment, investment income, and half of your Social Security benefits) exceeds certain thresholds, the IRS will tax a portion of your benefits.¹ Smart tax planning can help keep your income below those thresholds or time withdrawals from other sources to reduce taxation on benefits.

2. Traditional IRAs and 401(k)s

These accounts offer tax-deferred growth, meaning you don’t pay taxes on contributions or earnings until you withdraw the money. However, once you start taking distributions, they’re taxed as ordinary income. Withdrawals before age 59-1/2 will incur an additional 10% IRS penalty, too. This can push you into a higher tax bracket, especially once Required Minimum Distributions (RMDs) begin at age 73. Spreading withdrawals over time or converting to a Roth can help mitigate this.²

3. Roth IRAs and Roth 401(k)s

Withdrawals from Roth accounts are tax-free in retirement, assuming you’ve met the age and holding period requirements (you’re age 59-1/2 or older and the account has been open for at least 5 years) . They don’t count toward your taxable income or affect your Social Security taxation or Medicare premiums. Because of this, Roth accounts can be a powerful tool in tax-efficient retirement planning and can be used to help manage your taxable income in high-expense years.³

4. Taxable Brokerage Accounts

These accounts offer more flexibility but require careful planning. Interest income, dividends, and capital gains are all taxable in different ways. Long-term capital gains are generally taxed at lower rates, but poorly timed withdrawals or sales can lead to unnecessary taxes. Tax-loss harvesting and strategically selling investments may help minimize this burden.⁴

5. Pensions and Annuities

Pension income is typically taxed as ordinary income. Some annuities have more complex tax rules depending on how they’re funded and structured. If you purchased an annuity with pre-tax dollars, all withdrawals are fully taxable as ordinary income. If you purchased an annuity with after-tax dollars, part of each payment may be considered a return of principal and not taxed—but the interest portion will be.⁵ Understanding the tax implications of these streams helps you plan your overall income more effectively.

6. Real Estate and Business Income

If you retain rental properties or part-time business interests in retirement, that income must be reported and taxed.⁶ However, with the right strategy—like taking advantage of depreciation or qualified business income deductions—you can reduce what you owe. Planning ahead can help you structure these assets more efficiently for tax purposes.

Flexibility and Control in Retirement

A well-thought-out tax plan gives can give you greater control over your money and peace of mind. It may allow you to:

Manage your tax bracket strategically
Reduce required minimum distributions later in life
Avoid Medicare premium surcharges
Use charitable giving (like Qualified Charitable Distributions) to offset taxable income
Maximize legacy planning by passing on tax-efficient assets to heirs

Final Thoughts

At its core, retirement is about financial freedom—and that freedom is partially tied to how you manage taxes. Without a tax strategy, you risk losing more of your income to taxes than necessary, which can shorten the life of your retirement nest egg and limit your options.

The good news? With early planning and the right guidance, you can help minimize taxes, preserve your wealth, and enjoy the retirement you’ve worked so hard to achieve.