How retirement income is taxed & how to minimize your burden

Retirement may be the golden years, but taxes don’t retire with you. Many Americans are surprised to find that the money they spent decades earning – Social Security benefits, pensions, and retirement account withdrawals – is still subject to taxation. Understanding these tax rules before you leave the workforce can make a significant difference in how much of your retirement income you actually get to keep.

Social Security: not always tax-free

Unlike in the past, Social Security benefits are no longer automatically exempt from taxes. The government determines taxation on these benefits using a formula called “combined income,” which includes your adjusted gross income, tax-exempt interest, and half of your Social Security benefits. Yes, there is a proposal to eliminate taxes on Social Security, but for now, you’ll still need to know how to calculate it:

• If this amount is between $25,000 and $34,000 for individuals ($32,000 to $44,000 for couples), up to 50 percent of your benefits may be taxed.
• If it exceeds $34,000 ($44,000 for couples), up to 85 percent of benefits may be taxable.

This can come as a shock to retirees who believed their Social Security checks would be untouchable. The reality is that careful planning is needed to avoid unnecessary taxation.

Taxes on pensions & retirement account withdrawals

Pensions are relatively straightforward. If you contributed to your pension with pre-tax dollars, the full amount is taxable as regular income when you receive it. For Roth-based pensions, withdrawals are tax-free.

Withdrawals from tax-deferred accounts like traditional IRAs and 401(k)s are also fully taxable. Once you reach age 73, required minimum distributions (RMDs) force you to withdraw a set amount annually, which increases your taxable income – potentially pushing you into a higher tax bracket and triggering taxes on Social Security benefits as well.

On the other hand, Roth IRAs offer tax-free withdrawals in retirement, provided the account has been open for at least five years. Converting some of your traditional IRA or 401(k) into a Roth account before retirement can be a strategic way to reduce future tax burdens.

Key tax changes to watch

The transition to retirement brings new tax realities. Some key changes include:

• Loss of work-related deductions: Without a job, you can’t deduct expenses like 401(k) contributions or business-related expenses.
• Higher medical deductions: Medical costs can become a larger portion of income and may be deductible if they exceed 7.5 percent of adjusted gross income.
• State taxes: While some states don’t tax retirement income, others fully tax pensions and Social Security. Where you live can impact your total tax bill significantly.

Strategies to minimize taxes in retirement

Managing income sources carefully can help lower the overall tax burden. Here are a few strategies:

• Withdraw from taxable accounts first: Tapping brokerage accounts before tax-deferred accounts can help control taxable income levels.
• Delay Social Security benefits: Waiting until age 70 to claim benefits increases payments and can allow time to draw from taxable accounts first, reducing overall taxes.
• Use Roth conversions strategically: Converting portions of traditional IRAs to Roth IRAs during lower-income years can reduce taxable withdrawals later.

Be sure not to do the following:

• Ignore required minimum distributions. Missing an RMD can result in a 25 percent penalty.
• Make large withdrawals without a plan. A big lump-sum withdrawal from a 401(k) or IRA can push you into a higher tax bracket and trigger Medicare IRMAA surcharges!

Planning for taxes in retirement is as crucial as saving for retirement itself. Understanding how Social Security, pensions, and retirement withdrawals are taxed – and taking proactive steps – can make a substantial difference in preserving wealth during retirement.

Sylvia Gordon is the author of “Medicare Mama’s Guide to Medicare and Social Security Retirement.” She has over one million followers on social media where you can find her as “Medicare Mama” or @TheMedicareFamily. Her third-generation family insurance business is in central Indiana and licensed in all 50 states. Learn more at TheMedicareFamily.com.