Taxes in Retirement
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Retirement income is the money you receive after leaving the workforce. Common sources include Social Security, pensions, annuities, and withdrawals from retirement accounts such as 401(k)s and IRAs.
Different types of retirement income are taxed in different ways. Withdrawals from traditional retirement accounts are generally taxed as ordinary income, while qualified withdrawals from Roth accounts are usually tax-free. Pension payments are also commonly taxed as ordinary income. In addition, Social Security benefits may be partially taxable depending on your total income, and investment income from brokerage accounts may be taxed at separate capital gains rates.
Capital gains are profits from selling investments like stocks or mutual funds. If you hold an investment for more than one year before selling, you may qualify for the lower long-term capital gains tax rate. Short-term capital gains (from assets held one year or less) are taxed at your ordinary income tax rate. In contrast, withdrawals from most retirement accounts—unless they are Roth accounts—are taxed as ordinary income, which is typically higher than the capital gains rate for many retirees.
Depending on your total income, up to 85% of your Social Security benefits could be taxable. The IRS uses a formula called "combined income", which includes your adjusted gross income, nontaxable interest, and half of your Social Security benefits, to determine how much of your benefits are taxed. If your combined income exceeds certain thresholds, a portion of your Social Security will be included in your taxable income.
Planning the order in which you withdraw funds from different accounts can help minimize taxes. Many retirees benefit from withdrawing from taxable accounts first, then tax-deferred accounts (like traditional IRAs), and finally Roth accounts. This approach can help keep your taxable income lower in the early years of retirement and allow tax-advantaged accounts to continue growing.
To make the most of your retirement savings, consider strategies for tax-efficient withdrawals. Start by understanding your expected income needs and tax bracket. You might withdraw from taxable brokerage accounts first to take advantage of lower long-term capital gains rates. Next, consider taking required minimum distributions (RMDs) from your traditional IRAs or 401(k)s, as mandated by law. If you have Roth accounts, you can leave these untouched for as long as possible, since qualified withdrawals are tax-free and there are no RMDs during your lifetime. By carefully planning the sequence and amount of your withdrawals, you can help reduce your overall tax burden and stretch your retirement savings further.
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