How different kinds of retirement income are taxed

During working years, most income arrives as a paycheck with tax already withheld. In retirement, income usually comes from several sources at once, and the federal tax code treats each one differently. Knowing which category a dollar falls into explains a good deal about why two retirees with the same total income can owe quite different amounts of tax.

This article covers federal income tax only. It describes categories and concepts; the specific brackets and thresholds are adjusted every year and are published by the IRS.

Ordinary income: pre-tax accounts and pensions

The largest category for many retirees is ordinary income, taxed at the same graduated rates that apply to wages.

Traditional IRAs and pre-tax workplace plans. Money that went into a traditional IRA, 401(k), 403(b) or similar plan before tax is taxed when it comes out. IRS Publication 590-B explains that if only deductible contributions were made to a traditional IRA, distributions are fully taxable when received. If the owner made nondeductible contributions, part of each distribution is a tax-free return of that after-tax money. From age 73, yearly withdrawals are generally mandatory; see required minimum distributions.

Pensions. The IRS says pension or annuity payments from an employer plan are fully taxable if the recipient has no investment in the contract, which is the usual case when the employer funded the pension and the employee made no after-tax contributions. If the employee did contribute after-tax dollars, each payment is partially taxable.

Interest. Interest from bank accounts, certificates of deposit and corporate bonds held outside retirement accounts is generally taxable in the year it becomes available. The same IRS topic notes that some interest may be tax-exempt.

Roth accounts: generally not taxed

Roth IRAs and Roth accounts in workplace plans are funded with money that has already been taxed. A qualified distribution is not included in income at all. For a Roth IRA, that generally means the account holder has met a five-year requirement and is at least 59½, disabled or deceased, with a limited exception for a first home. The details are in the Roth IRA five-year rules.

Because qualified Roth distributions are not part of adjusted gross income, they also do not feed into the income-based calculations described later in this article.

Capital gains and dividends in ordinary investment accounts

Investments held in a regular, non-retirement account follow a different set of rules.

Capital gains. Selling an investment for more than its cost basis produces a capital gain. The IRS explains that a gain is generally long-term if the asset was held for more than one year, and that net long-term gains may be taxed at lower rates than ordinary income: 0%, 15% or 20% for most assets, depending on taxable income. Short-term gains, on assets held one year or less, are taxed as ordinary income. Only the gain is taxed, not the full sale proceeds.

Dividends. The IRS distinguishes ordinary dividends from qualified dividends, which are taxed at the lower capital gain rates. The year-end Form 1099-DIV shows which is which.

An important contrast: inside an IRA or 401(k), none of this applies. Gains, dividends and interest are not taxed as they occur, and the character of the income is lost. Everything withdrawn from a pre-tax account is ordinary income, even if it came from long-term growth.

Social Security and annuities

Social Security benefits may be partly taxable, depending on other income. The IRS explains that benefits are not taxable unless modified adjusted gross income plus one half of the benefits exceeds a base amount for the filing status. Above that level, a portion of the benefits is included in income. The thresholds and the calculation are covered in how Social Security benefits are taxed.

Payments from an annuity purchased with after-tax money outside a retirement plan are generally split into two parts: a return of the amount paid in, which is not taxed, and earnings, which are taxed as ordinary income. How the split is made depends on how the money is taken out. Annuities: the basic types and how they work describes the products themselves.

How the pieces interact

In summary, the general federal treatment of each source looks like this:

The categories in this summary are not independent. Total income determines the tax bracket, and several rules are keyed to adjusted gross income.

Consider a hypothetical retiree who takes an extra $20,000 from a traditional IRA for a home repair. That $20,000 is ordinary income. It may also cause more of their Social Security benefits to become taxable, may move some long-term capital gains from the 0% rate into the 15% rate, and may later affect Medicare premiums through the adjustment described in IRMAA: how income affects Medicare premiums. Had the same $20,000 come from a Roth IRA as a qualified distribution, none of those effects would follow. This is the reasoning behind holding more than one type of account, discussed in the three account buckets.

Withholding and estimated tax

No employer is withholding tax from most retirement income, so paying during the year takes some attention.

• Pension and annuity payers generally withhold federal income tax based on Form W-4P, according to the IRS.
• Where withholding does not cover the tax, the IRS says estimated tax payments may be needed during the year.

Most states with an income tax have their own rules for retirement income, and they differ widely. Because state laws and individual tax situations vary, a tax professional can advise on specifics.