When looking forward to retirement, many people envision traveling, enjoying leisure activities, and helping their loved ones financially. However, it’s important to take into account the impact of federal and state income taxes on retirement withdrawals, as how retirement income is taxed can significantly affect your finances. Most forms of retirement income, including Social Security benefits, pensions, and withdrawals from 401(k)s and traditional IRAs, are subject to taxation under U.S. tax laws. In addition, unless you reside in a state without an income tax, you can expect to pay state taxes on your retirement income. It’s important to research the tax laws in your state and understand how they will impact your retirement income. To help you plan, it’s worth examining the federal income taxes you’re likely to face on 12 common sources of retirement income.

Traditional IRAs and 401(k)s

Tax-deferred retirement accounts such as 401(k)s and traditional IRAs are popular among savers as they can reduce their current-year tax bills by lowering their taxable income. These accounts allow savings, dividends, and investment gains to grow on a tax-deferred basis, which can help increase the value of the account over time. However, it’s important to remember that the taxes on the gains and pretax contributions will need to be paid when the account holder retires and starts taking withdrawals. While withdrawals can be delayed, required minimum distributions (RMDs) must be taken from traditional IRAs and 401(k)s by the age of 72. If the account holder continues to work past age 72, they may be able to delay taking RMDs from their current employer’s 401(k) until they retire, as long as they own less than 5% of the company. Withdrawals from traditional IRAs and 401(k)s are subject to ordinary income tax rates, and early withdrawals before age 59½ may be subject to an additional 10% penalty in addition to regular tax. However, after-tax or nondeductible contributions are excluded from taxation.

Roth IRAs and Roth 401(k)s

Roth IRAs offer a significant long-term tax advantage, as contributions are not deductible but withdrawals are tax-free. However, there are two important considerations to keep in mind. Firstly, the account holder must have had a Roth IRA account for at least five years before they can take tax-free withdrawals. The five-year period starts when the first contribution or conversion from a traditional IRA is made to any Roth IRA account. Secondly, while the amount contributed can be withdrawn tax-free at any time, withdrawals of the gains are subject to an early-withdrawal penalty of 10% and can only be made once the account holder reaches age 59½.

Similarly, Roth 401(k)s have similar rules, where contributions are not deductible and withdrawals are tax-free as long as at least five years have passed since the first contribution was made to the account. The five-year period begins on January 1 of the year the first contribution was made to the Roth 401(k) and ends after five years.

Pensions

If you didn’t make any after-tax contributions to a private or government pension plan, any pension payments you receive are considered fully taxable at ordinary income tax rates upon receipt.
Social Security Benefits

Social Security Benefits

The taxation of Social Security benefits depends on a recipient’s provisional income, which is determined by adding 50% of their Social Security benefits to their income on Line 9 of Form 1040 or 1040-SR (excluding Line 6b) and tax-exempt interest. While some Social Security beneficiaries may not owe federal income tax on their benefits, others may have to pay taxes on up to 85% of them. For those with a provisional income of less than $25,000 ($32,000 for married couples filing jointly), their Social Security benefits are tax-free. If their provisional income is between $25,000 and $34,000 ($32,000 and $44,000 for joint filers), up to 50% of their benefits may be taxable. For those whose provisional income exceeds $34,000 ($44,000 for joint filers), up to 85% of their benefits may be taxable. To determine whether their Social Security benefits are taxable, individuals can use the IRS’s online tool.

Life Insurance Proceeds

If you receive proceeds as a beneficiary of a life insurance policy when the insured person passes away, those proceeds are usually not subject to taxation. However, if you are the holder of the policy and you decide to surrender it for cash, the tax implications are more complex. The taxability of these proceeds depends on the amount you receive and the premiums you have paid into the policy.

Generally, if the amount you receive upon surrendering the policy is greater than the amount of premiums you have paid, the excess is taxable as ordinary income. The taxable amount is the difference between the cash value of the policy and the premiums you have paid. If the amount you receive is less than the premiums you have paid, the difference is not taxable.

To determine the taxable amount of your life insurance proceeds, the IRS provides an online tool that you can use to calculate the taxable portion of any surrender or withdrawal from a life insurance policy.

Annuities

Annuities purchased with pretax funds, such as from a traditional IRA, are fully taxable because the funds were not taxed when they were contributed to the IRA. When you withdraw money from the annuity, it is taxed as ordinary income. Similarly, if you annuitize a portion of your traditional IRA or 401(k) plan, the entire payment is taxed at ordinary income tax rates.

Sales of Stocks, Bonds and Mutual Funds

When you sell stocks, bonds, or mutual funds that you’ve held for more than a year, the proceeds are taxed at long-term capital gains rates of 0%, 15%, or 20%. The specific rate depends on your income level and the amount of the gain. If you sell investments that you’ve held for a year or less, the gains are short-term and taxed at your ordinary income tax rate. If you sell at a loss, the loss can offset capital gains for the year, plus up to $3,000 of other income. Excess losses can be carried forward indefinitely each year, subject to the same tax treatment, until those losses are exhausted.

The 0%, 15% and 20% rates on long-term capital gains are based on set income thresholds that are adjusted annually for inflation. For 2022, the 0% rate applies to individuals with taxable income up to $41,675 on single returns, $55,800 for head-of-household filers, and $83,350 for joint returns. The 20% rate starts at $459,751 for single filers, $488,501 for heads of household, and $517,201 for joint filers. The 15% rate is for individuals with taxable incomes between the 0% and 20% break points. The income thresholds are higher for 2023. For 2023, the 0% rate applies to individuals with taxable income up to $44,625 on single returns, $59,750 for heads of household filers, and $89,250 for joint returns. The 20% rate starts at $492,301 for single filers, $523,051 for heads of household and $553,851 for joint filers. The 15% rate is for individuals with taxable incomes between the 0% and 20% break point. The favorable rates also apply to qualified dividends (see below). There’s also a 3.8% surtax on net investment income (NII) on top of the 15% or 20% capital gains rate for single taxpayers with modified adjusted gross incomes over $200,000 and joint filers over $250,000. This 3.8% extra tax is due on the smaller of NII or the excess of modified AGI over the $200,000 or $250,000 amounts.

Dividends

Retirees who own stock, either directly or through mutual funds, often receive dividends paid by companies to their stockholders. For tax purposes, these dividends are classified as either qualified or non-qualified. Qualified dividends are taxed at long-term capital gains rates, while non-qualified dividends are taxed at ordinary income tax rates.

Interest-Bearing Accounts

Savings Bonds

U.S. savings bonds such as EE and I bonds are generally taxable at ordinary income rates in the year they mature or are redeemed, whichever comes first, for federal income tax purposes. However, holders of HH bonds are required to report and pay U.S. tax on interest annually as it is paid to them. It’s important to note that interest on U.S. savings bonds is exempt from state and local income taxes.

If you plan to use EE and I bonds to pay for higher education, it’s possible for the interest to be tax-free if you follow certain rules. The bonds must have been purchased after 1989 by buyers who were 24 years of age or older. Additionally, they must be redeemed to pay for tuition or fees at a college, graduate school, or vocational school for the bondholder, their spouse, or dependent. However, it’s important to note that room and board costs are not eligible. Furthermore, the bonds must be in the taxpayer’s name, which means that grandparents can’t use this tax break to help pay for their grandchild’s tuition unless they can claim the grandchild as a dependent on their federal tax return.

The income exclusion is subject to income limits. For 2022, the exclusion begins to phase out for joint return filers with modified adjusted gross income over $128,650 and $85,800 for everyone else. The tax break disappears when modified AGI hits $158,650 and $100,800, respectively. For 2023, the exclusion begins to phase out for joint return filers with modified AGI over $137,800 and $91,850 for all other filers, and it disappears when modified AGI hits $167,800 and $106,850, respectively.

Home Sales

Retirees often have their home as their largest and most valuable asset, and the tax laws offer a significant federal income tax benefit when selling a primary home at a gain. If the property has been used and owned as the taxpayer’s personal residence for at least two out of the five years before the sale, they can exclude up to $250,000 of the gain from income ($500,000 for married couples filing jointly). Any gains beyond the $250,000 or $500,000 exclusion are subject to long-term capital gains rates. It’s important to note that losses cannot be deducted.

Reverse Mortgage Payments

That’s correct! When you receive payments from a reverse mortgage, they are considered loan proceeds and not taxable income. This means that you don’t have to report the payments as income on your tax return. However, the interest you eventually pay on the reverse mortgage is generally not tax-deductible unless you used the original proceeds to buy, build, or substantially improve the home securing the loan. If you did use the proceeds for these purposes, you may be able to deduct the interest on your tax return, subject to certain limitations.

If you’d like to find out more about how your personal retirement income may actually be taxed, feel free to reach out to Lynn at lynnt@herretirement.com.