What You Should Know About Taxes in Retirement

Source: IRS

Income is income, as far as the IRS is concerned—whether you’re working or retired. That can come as a surprise to retirees who are beginning to receive Social Security benefits and starting to tap into their IRAs. Generally, the more income you make the higher your tax rate, though your tax rate may also vary by the income source.

So, some retirees pay close attention to the IRS’ tax brackets, which adjust slightly every year for inflation (see accompanying 2019 tax bracket table). They avoid making IRA withdrawals or other financial moves within any given year if it could suddenly push them into a higher bracket, increasing their tax rate by up to 10%. But their efforts may not always succeed, and a big reason is that periodic withdrawals from traditional IRA accounts become mandatory (aka “required minimum distributions”) in your 70s.² More on this later.

All this time, you may have thought of Social Security as a tax—and suddenly, in retirement, you’re taxed on your Social Security benefits. How could that happen?

The answer may depend on your other sources of income. The IRS’ calculation, called “combined income,” looks at your adjusted gross income, plus nontaxable interest (e.g., from municipal bonds), plus half of your Social Security income. If your combined income is below $25,000 (or $32,000 if married filing jointly), your benefits are not likely to be taxed. However, if your combined income is between $25,000 and $34,000 ($32,000-$44,000, if married filing jointly), you probably have to pay federal income tax on up to half of your Social Security benefits. Over $34,000 ($44,000, if married), you’d usually owe tax on 85% of the benefits.³ Thirteen states also tax Social Security benefits.⁴

Some retirees—those who can afford to do so—delay taking Social Security benefits well beyond the minimum age of 62. Delaying Social Security benefits can sometimes help avoid a large “combined income” tax bill. Also, regardless of your reason, if you delay, the monthly amount you get when you finally do begin taking benefits increases until you reach age 70.⁵

For many people in retirement, however, Social Security represents their primary source of income. Among the 44.5 million retirees and their dependents who receive benefits, 50% of married couples and 70% of individuals get half or more of their income from Social Security. Their average monthly benefit was $1,471, as of June 2019.⁶ The bottom line is, if you are living only on Social Security, you are unlikely to owe taxes.

The U.S. government encourages saving money for retirement, so when it comes to savings accounts, it designed IRAs (set up by individuals, as the name implies) and employer-sponsored 401(k)s to help you grow retirement savings tax-free while you’re still working. 401(k)s are typically converted into IRAs upon retirement.

In retirement, though, the tax treatment of IRAs can be complicated. For instance, tax varies significantly between traditional IRAs and Roth IRAs. You have to pay taxes on withdrawals from traditional IRAs, and you have to start making withdrawals as “required minimum distributions” when you reach 72. If not, you could face a tax penalty.⁷ Not so with Roth IRAs. Withdrawals from Roth accounts are tax-free and can be taken at any time after you reach the age of 59-1/2.⁸ The difference stems from the fact that traditional IRAs are funded with pre-tax money, so you never paid income tax on it in the first place; Roth IRAs are funded with after-tax dollars.

Large required minimum distributions from IRAs can trigger large federal and state income tax bills. Another type of income subject to tax in retirement is gains in a regular non-retirement brokerage account of stocks, bonds, and mutual funds. As you cash out holdings in these accounts during your retirement, taxable earnings are subject to 0%-20% in capital gains taxes (as of tax-year 2019), depending on your income.⁹

Some retirees work with financial advisors on various ways to minimize the tax they pay in retirement, such as delaying Social Security benefits, timing withdrawals of traditional IRA and Roth IRA income, using their IRA distributions for charitable contributions, and closely accounting for medical and other deductions.

While most states tax at least a portion of retirement income, financial publisher Kiplinger lists 12 states that do not, including seven that have no income tax at all.¹⁰ But that may not tell the entire story for retirement taxes. State and local property and sales taxes can be another big factor in your retirement budget. Combined with state income taxes, they can determine whether where you live is or isn’t “retirement-friendly.”

Lists of the best places to retire abound, including the “tax-friendliest.”¹¹ For example, a WalletHub analysis of the average total tax burden—including income, property, and sales and excise taxes—identified New York as the highest-tax state and Alaska as the lowest-tax state.¹² The other four lowest-tax states are:

• Delaware
• Tennessee
• Florida
• New Hampshire 

But the landscape can change. For example, a federal law in 2017 capped state and local tax deductions at $10,000, as part of a larger tax overhaul. The effects are setting in, with some people who are at or near retirement age picking up and moving out of high-tax states. “Taxpayers Decide Some States Aren’t Worth It,” read a recent headline in the Wall Street Journal.¹³