How Retirement Income is Taxed: What You Need to Know

When planning for retirement, most people focus on saving money — 401(k)s, IRAs, pensions, and Social Security. But what often gets overlooked is how that income is taxed once you retire. At Avalon Tax, we believe smart tax planning is just as important as financial planning, especially in your golden years. Here’s a clear look at how retirement income is taxed and what you need to know to avoid surprises.

1. Social Security Benefits: Taxed Depending on Total Income

Contrary to common belief, Social Security benefits can be taxable, but it depends on your overall income. The IRS uses a formula called “combined income” (adjusted gross income + nontaxable interest + half of your Social Security benefits) to determine how much of your Social Security is taxable.

• If you're single and your combined income is:

  • Less than $25,000: benefits are tax-free.

  • $25,000–$34,000: up to 50% of benefits may be taxable.

  • Over $34,000: up to 85% of benefits may be taxable.

• If you're married filing jointly:

  • Less than $32,000: tax-free.

  • $32,000–$44,000: up to 50% taxable.

  • Over $44,000: up to 85% taxable.

Tax Tip: Consider strategies to manage income levels in retirement, such as Roth conversions or tax-free municipal bonds.

2. 401(k)s and Traditional IRAs: Fully Taxable

Withdrawals from traditional IRAs and 401(k)s are taxed as ordinary income because the contributions were made pre-tax. Starting at age 73 (or 75 if you were born in 1960 or later), the IRS requires Required Minimum Distributions (RMDs), and failing to take them can result in hefty penalties.

Tax Tip: If you expect to be in a lower tax bracket in retirement, this setup can be beneficial. However, retirees with substantial savings may want to consider partial Roth conversions before RMDs begin.

3. Roth IRAs and Roth 401(k)s: Tax-Free Withdrawals

Withdrawals from a Roth IRA or Roth 401(k) are completely tax-free, as long as:

• The account has been open for at least 5 years.

• You’re at least 59½ years old.

These accounts are powerful tools in retirement because they don’t increase your taxable income — and they won’t push you into a higher tax bracket or affect Social Security taxation.

Tax Tip: Diversifying your retirement accounts between traditional and Roth options can offer flexibility and control over your taxable income.

4. Pensions: Usually Fully Taxable

If your employer funded your pension, your distributions will be fully taxable as ordinary income. However, if you contributed after-tax dollars to your pension plan, a portion of each payment might be tax-free.

Be sure to review your pension documents or talk to a tax advisor to understand how much of your benefit is taxable.

5. Annuities: Depends on Type and Contributions

Income from annuity contracts is partially taxable:

• If purchased with after-tax dollars, only the earnings are taxable.

• If purchased with pre-tax dollars, like from a rollover IRA, the entire distribution is taxable.

The IRS uses a formula to separate each payment into a taxable and non-taxable portion, known as the exclusion ratio.

6. Investment Income and Capital Gains

If you’re drawing income from investments — such as dividends, capital gains, or interest — these are taxed differently based on the source:

• Qualified dividends and long-term capital gains are taxed at lower rates (0%, 15%, or 20%).

• Interest income and short-term gains are taxed as ordinary income.

Tax Tip: Selling appreciated assets strategically or harvesting losses can help reduce capital gains tax liability.

Plan Proactively

Understanding how your retirement income is taxed is critical to maximizing your nest egg and minimizing surprises. At Avalon Tax, we specialize in helping retirees and pre-retirees build tax-smart strategies so they can enjoy their retirement years with confidence.

Whether you’re already retired or just starting to plan, reach out to Avalon Tax for a personalized consultation. We'll help you make informed decisions today that can lead to major tax savings tomorrow.