Do You Have To Pay Taxes on Your Retirement Income? It Depends

Senior man using a calculator while reviewing his budget
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If you’ve saved and invested carefully over the years, you may expect a nice payout in retirement. But once you’re retired and enjoying those funds, how much of your income will go back to Uncle Sam? Here’s what you need to know about taxes in retirement as you plan for the future.

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Expect To Pay Income Taxes on Your Pension Income

Although pension funds are becoming less common, many public sector employees still have them and rely on that income. When the check arrives in the mail, though, don’t count on keeping the full amount.

When you receive your pension payments (whether periodically or in one lump sum), you will have to pay regular federal income taxes on the amount when you file your tax return, according to the Financial Industry Regulatory Authority (FINRA). The only exception is if you contributed any after-tax dollars to your pension. Those funds won’t be taxed when you withdraw them, according to the IRS.

Make Your Money Work

Some states impose state-level income tax as well, so be sure to research your state’s tax rules on pension income or speak with your accountant.

In general, it’s a good idea to wait to receive pension payments until you’re 59 ½ years old. Any earlier and you’ll have to pay an additional 10% tax.

Keep in mind that if you’re 65 or older, you don’t have to file a tax return at all if your income was under $14,250 for tax year 2021. If you and your spouse are 65 or older and are filing jointly, you don’t have to file a return if your income was under $27,800. These amounts set by the IRS are specific to 2021 and will likely increase each year.

Whether You Pay Taxes on Retirement Investments Depends on the Account Type

Not all retirement accounts are taxed the same. In fact, you don’t have to pay any taxes on withdrawals from Roth IRAs and Roth 401(k) plans. Your after-tax contributions allow you to receive funds tax-free in retirement as long as you have owned the account for at least five years.

You can expect to pay taxes, though, on any tax-deferred investment accounts. This includes self-directed traditional IRAs and SEP IRAs as well as employer-sponsored plans like a 401(k), 403(b)s and 457.

Make Your Money Work

“When you make withdrawals from traditional retirement accounts, they are subject to ordinary income taxes, which currently range in seven brackets from 10% to 37% in the U.S.,” said Riley Adams, a CPA and founder of Young and Invested.

With a traditional account, you must begin withdrawing distributions of a certain amount once you turn 72. If you don’t, you have to pay a 50% excise tax on the funds you were supposed to withdraw but didn’t. Roth IRAs don’t require distributions until after death.

How Much Your Social Security Benefits Are Taxed Depends on Your Income

Unlike pensions and traditional IRAs, you don’t pay ordinary income tax on all of your Social Security benefits. Instead, the taxable amount depends on your provisional income.

What’s your provisional income? It’s simply your adjusted gross income plus your tax-exempt interest and half your Social Security benefits.

You can use Worksheet 1 in IRS Publication 915 to figure out exactly how much you’ll pay in taxes on your Social Security benefits. In general, though, if your provisional income is below $25,000 (or $32,000 for joint filers), your benefits are tax-free.

Make Your Money Work

If it falls between $25,000 and $34,000 (or $32,000 to $44,000 for joint filers), half of your Social Security benefits are taxable. But if your provisional income is greater than $34,000 (or $44,000), you must pay taxes on up to 85% of your benefits.

Find Out: All You Need To Know About Collecting Social Security While Still Working

Save Money on Taxes in Retirement by Diversifying Your Investments

Adams recommends diversifying your investment strategy to avoid hefty taxes in retirement. This includes opening both Roth and traditional IRA accounts.

Buying and holding dividend stocks in a growing U.S. company is another savvy way to potentially pay less in taxes. After all, qualified dividends and long-term capital gains aren’t subject to ordinary income tax. Instead, you pay a lower rate of anywhere between 0% to 20% depending on your income.

If you’re looking to downsize, consider using the Section 121 exclusion when you sell your home. This allows you to exclude from your tax return up to $250,000 of the profits from your home’s sale if you’re a single filer and up to $500,000 if filing jointly.

“This isn’t necessarily income, but it’s a way for many retirees to leverage tax-free returns as they downsize their lives to reflect a lower cost of living,” Adams said.

Lastly, consider giving tax-free gifts up to a certain amount set by the IRS before your death. You can give even larger tax-free gifts to your beneficiaries throughout your lifetime. Just make sure to carefully follow the IRS’ rules outlined in Form 709.

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About the Author

Jenny Rose Spaudo is content strategist and copywriter specializing in personal and business finance, investing, real estate, and PropTech. Her clients include Edward Jones, Flyhomes, PropStream, and Real Estate Accounting Co. As a journalist, her work has appeared in Business Insider, GOBankingRatesMovieguide®, and various smaller publications. She’s also ghostwritten a book and hundreds of articles for CEOs and thought leaders. Before going freelance, Jenny Rose was the online news director for Charisma Media, where she oversaw three online magazines, hosted a daily news podcast, and managed the editorial content for the company’s robust podcast network. In 2014, she graduated summa cum laude from Stetson University with bachelor’s degrees in Communication & Media Studies and Spanish. During her college career, she won two awards for her research and was named “Top Senior” in both her majors. Find her at jennyrosespaudo.com and connect with her on LinkedIn.

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