Will You Pay Taxes During Retirement?

Retirement might mark the end of your career, but it doesn't necessarily mark the end of your tax obligations. Depending on your income sources and where you live, taxes can still take a bite out of your retirement income. Thankfully, understanding how different income streams are taxed can help you plan ahead, preserve more of your nest egg, and avoid surprises come tax season.

Understanding Retirement Income Sources

Retirement income can come from various buckets, and each has unique tax rules, says Daniel Milks, founder of Woodmark Advisors.

Most retirees rely on a combination of income streams to cover living expenses, and each source is taxed differently. Common sources include Social Security benefits, pension payments, withdrawals from retirement accounts like IRAs and 401(k)s, and earnings from investments. Some retirees also continue working part-time, which adds earned income to the mix.

Social Security and Taxes

Social Security benefits are a crucial part of many retirees' income, but they may not be tax-free. Whether you owe taxes on your benefits depends on your total income and filing status. According to IRS rules, up to 85% of your Social Security benefits could be taxable if your combined income exceeds certain thresholds.

Combined income includes half of your Social Security benefits, plus any other taxable income such as pensions or withdrawals from retirement accounts, along with tax-exempt interest. For individuals earning over $34,000 or married couples earning over $44,000, up to 85% of benefits may be taxed. Keeping these thresholds in mind can help you avoid unnecessarily inflating your tax liability.

Taxation of Pension and Annuity Income

Pensions and annuities are typically treated as ordinary income for tax purposes. Pension payments are fully taxable if they were funded entirely with pre-tax dollars, meaning you didn’t contribute any after-tax money. If you made after-tax contributions to your pension or annuity, part of each payment will be tax-free, representing a return of your after-tax investment, and the remainder is taxable as ordinary income. The exact taxable portion is calculated using IRS guidelines, typically through the simplified method or general rule.

Lump-sum payouts can push retirees into higher tax brackets, while periodic payments may offer more predictable, manageable tax consequences, notes Milks. "Pensions can provide guaranteed income for life, but they often lack the flexibility of retirement accounts," he points out.

Tax-Deferred Retirement Accounts

Withdrawals from traditional IRAs, 401(k)s, and similar tax-deferred accounts are fully taxable as ordinary income—with rates ranging from 10% to 37%. Most retirees need to start taking required minimum distributions (RMDs) from these accounts at age 73, and failing to withdraw the appropriate amount can result in steep penalties.

Because withdrawals from tax-deferred accounts add to your taxable income, the timing and amount of your distributions can significantly impact your tax bill, so make sure to keep that in mind.

Roth Accounts and Tax Benefits

Roth IRAs and Roth 401(k)s offer retirees a powerful tax advantage. Contributions to these accounts are made with after-tax dollars, but qualified withdrawals in retirement are entirely tax-free.

Roth accounts can be an essential part of managing taxes in retirement, Milks says. Not only do they provide tax-free withdrawals, but they also don’t require RMDs, giving retirees more control over when they tap into these funds. This flexibility is especially useful for retirees aiming to minimize their taxable income in specific years.

State Taxes on Retirement Income

In addition to federal taxes, retirees need to consider how their state treats retirement income. Some states fully tax retirement income, while others exempt Social Security benefits, pensions, or IRA withdrawals.

A handful of states, including Florida and Texas, have no state income tax at all—and relocating or structuring withdrawals to take advantage of this can help minimize taxes during retirement, says Leyder "Aiden" Murillo, founder of Wolfpack Wealth Management.

Investment Income and Capital Gains

If you're a retiree who continues to hold investments outside of retirement accounts, then income from dividends, interest, and capital gains can affect your tax situation. Qualified dividends and long-term capital gains benefit from lower tax rates than ordinary income, making them an attractive source of retirement income.

However, realizing significant capital gains in one year can increase your taxable income and potentially lead to higher taxes on Social Security benefits and Medicare premiums. As Justin Pritchard, founder of Approach Financial, advises, managing the timing of your capital gains is one of the best ways you can avoid creeping into higher tax brackets during retirement.

Strategies to Minimize Taxes in Retirement

Retirees have several strategies at their disposal to keep taxes in check. Milks recommends diversifying income sources across taxable, tax-deferred, and tax-free accounts to give yourself more flexibility.

One common tactic involves tapping taxable accounts first, allowing tax-deferred accounts to grow and delaying RMDs. During low-income years, converting funds from traditional IRAs to Roth IRAs may also make sense, allowing you to pay taxes at a lower rate. Additionally, using capital losses to offset gains can reduce investment income taxes.

Estate Planning and Gifting

Estate planning isn’t just about passing wealth to heirs—it can also play a role in managing taxes. Milks points out that gifting assets during your lifetime can help reduce the size of your taxable estate. However, he cautions retirees to be mindful of the tax consequences.

“If the asset is highly appreciated, it could trigger significant tax liabilities upon sale by the recipient,” he says. As a result, familiarizing yourself with annual gift tax exclusions and the lifetime gift tax exemption can help you gift strategically while minimizing tax liabilities.

The Bottom Line

Taxes don’t end when you retire, but with careful planning, they don’t have to derail your financial stability. Understanding how different income sources are taxed—whether it’s Social Security, pensions, retirement accounts, or investments—can help you manage your tax burden effectively.

Additionally, combining smart withdrawal strategies, taking advantage of Roth accounts, and incorporating estate planning can further optimize your tax situation. If you're facing a particular concern or unsure where to start, consult a financial advisor or tax professional to make the most of your hard-earned savings.