How the IRS Taxes Retirement Income: What’s Taxable, What’s Not, and Planning Tips
Retirement planning starts with knowing how the IRS taxes different types of income.
Today, we’ll break down the IRS’s tax rules for retirement income and income sources that aren’t taxed.
But first, you need to know this year’s marginal tax rates and how they work.
2025 Marginal Tax Rates Explained
Marginal tax rates mean you’re only taxed at higher rates on the portion of your income that falls within each tax bracket, not your entire income—so earning more doesn’t mean all of your income is taxed at the highest rate.
Example: Let’s say you are single filer (not married) and will have $150,000 in taxable income this year.
1. Your first $11,925 is taxed at 10% = $1,192.50
2. Your next $36,550 is taxed at 12% = $4,386.00
3. Your next $54,875 is taxed at 22% = $12,072.50
4. Your next $46,650 is taxed at 24% = $11,196.00
Total tax: $1,192.50 + $4,386.00 + $12,072.50 + $11,196.00 = $28,847.00
Even though the highest rate you’d pay is 24%, not all $150,000 is taxed at that rate—only the portion above $103,350. Most of your income is taxed at the lower rates.
Taxable Income Sources in Retirement
Social Security Benefits:
Partially Taxable: Up to 85% of your benefits may be subject to federal income tax, depending on your “provisional income.” Provision income includes half of your Social Security benefits plus all other income (taxable and tax-exempt).
Thresholds for 2025:
Single filers: Tax begins if provisional income exceeds $25,000.
Married filing jointly: Tax begins if provisional income exceeds $32,000.
Traditional IRAs and 401(k)s:
Fully taxable as ordinary income when distributions are made, assuming contributions were made pre-tax.
Required minimum distributions (RMDs) begin at age 73.
Pension Income:
Taxed as ordinary income. If you contributed after-tax dollars, part of the income might be tax-free.
Investment Income:
Interest and Dividends:
Interest from savings and taxable accounts is taxed as ordinary income.
Qualified dividends receive favorable long-term capital gains tax rates (0%, 15%, or 20%).
Capital Gains:
Gains from selling assets held over a year are taxed at capital gains rates.
Gains on assets held for less than a year are taxed as ordinary income.
Capital gains are taxed by “stacking” them on top of your ordinary income.
Annuities:
Taxable if purchased with pre-tax funds.
Only earnings are taxable if purchased with after-tax dollars.
Rental Income:
Net rental income is subject to ordinary income tax.
Depreciation and other deductions can offset taxable income.
Part-Time Work or Side Gigs:
Wages and self-employment income are subject to ordinary income tax and Social Security/Medicare taxes.
Early Withdrawals from Retirement Accounts:
Withdrawals made before age 59½ may incur a 10% penalty in addition to being taxed as ordinary income.
Certain exceptions, such as medical expenses or first-time home purchases, may waive the penalty.
Non-Taxable Income Sources
Roth IRAs and Roth 401(k)s:
Tax-free qualified withdrawals (contributions and earnings) if the account has been open for at least five years and you’re 59½ or older.
Life Insurance Proceeds:
Death benefits are generally not subject to income tax.
Municipal Bond Interest:
Exempt from federal income tax and, in many cases, state tax if issued in your state of residence.
Veterans Benefits:
Payments related to disability, pensions, and education assistance are tax-exempt.
Healthcare Accounts (HSAs):
Distributions used for qualified medical expenses are tax-free.
Withdrawals from a Health Savings Account (HSA) that are not used for qualified medical expenses are subject to income tax and a 20% penalty. However, the 20% penalty goes away if the withdrawal is made after age 65.
Additional Questions About Retirement Taxes
How Does Tax Withholding Work on Retirement Income?
Taxes are often withheld from pensions, annuities, and IRA distributions. Retirees should review and adjust their withholding amounts to avoid overpayment or underpayment.
How Can Social Security Taxes Be Minimized?
Retirees can structure withdrawals to stay below provisional income thresholds and reduce the percentage of benefits subject to tax.
How Do State Taxes Affect Retirement Income?
Some states fully tax retirement income, others exempt Social Security or provide specific tax breaks for pensions. Understanding your state’s tax rules is crucial.
What Are the Tax Implications of Selling a Primary Residence in Retirement?
Homeowners may exclude up to $250,000 ($500,000 for married couples) of capital gains from the sale of a primary residence if they meet the ownership and use tests.
What Happens if Retirees Move Abroad?
U.S. citizens must continue to report and pay taxes on worldwide income. Tax treaties and foreign earned income exclusions may mitigate some of this burden.
Tax Planning Tips
Strategize Withdrawals:
Withdraw funds in a way that minimizes tax liability, such as using Roth accounts later to avoid bumping into higher tax brackets.
Optimize Capital Gains:
Time the sale of assets to stay within lower capital gains brackets.
Leverage Tax-Free Income:
Include non-taxable sources, like Roth accounts or municipal bond interest, to reduce overall taxable income.
Consider State Taxes:
Some states do not tax retirement income at all, while others exempt Social Security benefits or offer tax breaks for pension income.
Work with a Professional:
A tax or financial advisor can tailor strategies to your unique situation, ensuring tax efficiency in retirement.
In Closing
By understanding these rules and planning accordingly, you can make the most of your retirement income and minimize your tax burden.
To your Atomic Retirement,
Ryan Kilkenny
P.S. If you have a question or would like help planning for retirement, you can schedule an appointment here.
