Is retirement income taxable? It depends on where that income comes from and how much of it you will have.
The major types of retirement income are either taxable, partially taxable, or tax-free. Learn which types of retirement income you will need to pay tax on, including pensions, retirement plans, Roth IRAs, and more.
- Withdrawals from retirement plans and pensions and investment income from non-retirement accounts are typically taxable.
- Social Security income may be taxable depending on your income and tax filing status.
- Roth IRA withdrawals and income from reverse mortgages are not taxable.
Taxable Sources of Retirement Income
Expect that all 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plan was funded with pretax dollars, whether by you or your employer, it will result in taxable retirement income when withdrawn. Expect withdrawals from traditional IRAs, 401(k)s, 403(b)s, SEPs, and other similar types of plans to be taxable.
The 10% penalty on early withdrawal from IRAs was suspended for 2020 by the CARES Act. It also allowed for the income from any withdrawal to be spread out over three years to reduce the tax hit. The CARES Act also allows taxpayers to file for recovery of taxes paid if the withdrawals are repaid within three years.
- Pension income: Most pensions are taxable; however, some types of military pensions or disability pensions may be partially or entirely tax-free. Your pension provider will send you a 1099 form at the beginning of each year that shows you how much of your pension is taxable. If you paid part of the cost of your pension, you can exclude part of each payment from your income.
- Investment income in non-retirement accounts: Dividends that occur in non-retirement accounts will be reported to you on a 1099-DIV form, while capital gains and interest will come on a form 1099-B each year. You will pay tax on most of this type of investment income as it is earned. The exception would be any capital gains that fall into the 0% tax rate; you won't pay tax on that portion of capital gains.
Interest, dividends, and capital gains that occur within tax-deferred accounts, such as IRAs or 401(k) plans, are not taxable in the year they occur. Instead, income within these accounts is deferred until you make a withdrawal. At the time of withdrawal, the withdrawal amount is taxable, with the exception of tax year 2020, when COVID-related withdrawals could be spread over three years for tax purposes.
- Withdrawals from an annuity: When you take withdrawals from a fixed or variable annuity (one that is not held in an IRA or retirement account), any gain must be withdrawn first. This gain is taxed as ordinary income.
Partially Taxable Retirement Income
The following sources of retirement income are partially taxable. How much is taxable depends on different factors.
- Social Security: Anywhere from 0% to 85% of your Social Security income may be taxable; at least 15% will always be tax-free. How much of your Social Security income is taxable depends on your income and tax filing status. If you are married and filing separately, you will likely pay tax on your Social Security benefits.
- Nondeductible IRA withdrawals: If you have traditional pretax individual retirement account (IRA) contributions as well as after-tax, nondeductible IRA contributions, then a portion of each nondeductible IRA withdrawal may be considered a gain, and a portion would be the return of your basis. The gain portion is considered taxable retirement income.
- Income from an immediate annuity that 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 a return of principal. The interest portion is taxable. If the immediate annuity was purchased with pretax money, such as in an IRA or other retirement account, all of the income will be taxable.
- Cashing in a cash-value life insurance policy: Cash-value life insurance policies have a cost basis, usually the total of all premiums you have paid. If your cash value exceeds your basis when you cash in the policy, that portion will be taxable.
Tax-Free Retirement Income
The following sources of retirement income are generally tax-free:
- Roth IRA withdrawals: Roth IRA withdrawals are tax-free if you meet the Roth IRA withdrawal requirements. Roth IRA withdrawals are not included in the formula that determines how much of your Social Security is taxable. They also are not 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.
- 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 people overlook.
- Any return of principal or cost basis: Once all gain has been withdrawn from an annuity, you would be withdrawing your cost basis or principal. Withdrawals of basis are not counted as taxable retirement income.
- Gain from the sale of your home: Most people receive gains from the sale of their primary residence tax-free if the gain is less than $250,000 for a single person or less than $500,000 for married filers, and if the seller has lived in the home for at least two of last five years and meets other IRS requirements.
Calculating Taxes in Retirement
Taxes in retirement can vary tremendously, based on where the income is coming from. The tax rate on the different types of retirement income can also vary widely; income may be taxed at the ordinary income tax rate, as capital gains, or at a completely separate rate.
No matter what types of income you have, always follow IRS guidelines when paying estimated taxes or preparing your tax returns. The rules for what is and is not taxable may change unexpectedly, depending on new state and federal laws.
If you are unsure whether your retirement income is taxable (or, if so, at what rate), consult a tax specialist to ensure that you avoid any IRS penalties or audits.
The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.