Is retirement income taxable? It depends on where your retirement income comes from, and how much of it you will have.
Below is a list of common sources of retirement income, broken down into taxable retirement income, partially taxable retirement income, and tax-free retirement income.
Use this list only for general guidance. You must use IRS guidelines, which can change, or a qualified tax preparer who is familiar with your finances, to give you a final say on which items will result in taxable retirement income.
Taxable sources of retirement income
Expect that all of the following types of retirement income will be taxable at your ordinary income tax rates.
Withdrawals from retirement plans – If a plan was funded with pre-tax dollars, whether by you or your employer, it will result in taxable retirement income when withdrawn. Expect pretty much all withdrawals from IRAs, 401(k)s, 403(b)s, SEPS, SIMPLES and other similar types of plans to be taxable.
Pension income – Most pensions are taxable, however some types of military pensions or disability pensions may be partially or entirely tax-free. The provider of your pension will send you a 1099 form at the beginning of each year that shows you how much of your pension is taxable.
Investment income in non-retirement accounts – Interest, dividends and capital gains that occur in non-retirement accounts will be reported to you on a 1099 form each year and you will pay tax on most of this type of investment income as it is earned.
Instead, all such investment income within these types of accounts is deferred until you take a withdrawal. At the time of withdrawal, the withdrawal amount is taxable.
Withdrawals from an annuity – When you take withdrawals from a fixed or variable annuity (one that is not owned by an IRA or retirement account) the IRS rules say any gain must be withdrawn first, and this gain is taxed as ordinary income. Once all gain has been withdrawn, you would be withdrawing your cost basis or principal. Withdrawals of basis are not counted as taxable retirement income.
Partially taxable retirement income
The following sources of retirement income are not entirely taxable.
Social Security – Anywhere from zero up to 85% of your Social Security income may be taxable, but never 100% of it. If your other sources of income are below the thresholds set by the IRS then all your benefits will be tax-free, but if your other sources of income are in excess of the threshold, then a formula determines what percentage of your benefits will be subject to taxation.
The good news is 15% of your Social Security benefits will always be tax-free.
Non-deductible IRA withdrawals – If you have traditional pre-tax IRA contributions as well as after-tax, non-deductible IRA contributions, then a portion of each non-deductible IRA withdrawal may be considered gain and a portion would be return of your basis. The gain portion is considered taxable retirement income.
Income from an immediate annuity which was purchased with after-tax money – When you buy an immediate annuity with after-tax money a portion of each payment you receive is interest, and a portion is return of principal. The interest portion is taxable. If the immediate annuity was purchased with pre-tax money, such as in an IRA or retirement account, all of the income will be taxable.
Proceeds from cashing in a cash value life insurance policy – Cash value life insurance policies have a cost basis – which is usually the total of all premiums you have paid. When you cash in the policy if your cash value exceeds your basis, then that portion is considered a gain and will be taxable. Beware – if you have an outstanding loan on the policy it gets more complicated. After you take a loan from a life insurance policy if you terminate the policy before repaying the loan, then a portion of the loan amount may become taxable income to you.
Tax-free retirement income
And last, but not least, the best kind of income – the tax-free kind. The following sources of income are generally tax-free.
Roth IRA withdrawals – are tax-free if you meet the Roth IRA withdrawal requirements. In addition, Roth IRA withdrawals is they are not included in the formula that determines how much of your Social Security is taxable, nor are they included in the formula that determines how much in Medicare Part B premiums you will pay.
Interest income from municipal bonds – Most municipal bond income is free from federal income taxes, but you may be subject to state income taxes on this form of retirement income.
Loans from life insurance policies.
Income from a reverse mortgage – monthly payments or lump sums received from a reverse mortgage are not taxable. This gives a reverse mortgage a hidden advantage that many folks overlook.
After-tax contributions – If you saved money after-tax in a 401(k) or other company plan then when you withdraw that portion it is not taxable.
Any return of principal or cost basis – For example, suppose you purchased a variable annuity with $10,000 of after-tax money. You cash it in at age 60 when it is worth $12,000. The $2,000 of gain is taxed as ordinary income. The $10,000 is your cost basis, or original principal, and is not taxable income to you.
Gain from the sale of your home – Most people get receive gains from the sale of their primary residence tax-free. If gain is less than $250,000 for a single, or less than $500,000 for married filers, you have lived in home for at least two of last five years and met other IRS requirements.
As you can see from the list above, taxes in retirement can vary tremendously based on where the income is coming from. However, with proper saving and planning, you can reduce the total amount of taxes you pay in retirement.
Last posted by Dana Anspach at thebalance.com