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Taxation of retirement income streams

| May 21, 2024

Funding your retirement means piecing together a total stream of income, typically from multiple sources, to meet your expense needs. And just because you have retired, doesn’t mean you have retired from the purview of the IRS. They want to get their hands on portions of any possible income sources, while you want to keep as much in your pocket as possible.

As such, understanding how various sources of income are taxed in retirement is critical to developing an income plan that minimizes taxes and thus prolongs the useful life of your assets. Here we’ll look at how these different sources are taxed, starting with the most favorable and working down. You’ll notice that these don’t follow a perfect flow of least to most, as there are circumstances where the same asset can trigger no taxes or lots of taxes. We’ll point these out along the way. It’s also important to note that you don’t always want to simply work from top to bottom on this list. There are cases where you may want to accelerate taxation, just the same as there are cases where you want to defer taxation (more common). There are also less favorable income streams (such as from pre-tax retirement accounts) that you may want to avoid, but you can’t thanks to things like required minimum distributions (RMD). All that said, it’s good to map out a general plan, and then revisit it annually depending on current needs, circumstances, and tax laws.

Of course, not all of these streams are going to apply to you. Every circumstance is unique. With that, let’s get started.

Checking / savings account – This one might go without saying but needs to be mentioned anyway. You can always take funds from your cash accounts (checking, savings, money market, CD, etc.) without incurring taxes of any sort.

Brokerage account – Withdrawals of cash from a brokerage account (also called a ‘non-retirement account’ or ‘taxable investment account’) are tax-free. However, to raise the funds necessary to access this cash, you may need to sell investments from within the account. When you do, you may realize capital gains and/or losses. Capital gains are taxable at favorable rates relative to ordinary income (15.0-23.8% federally, varies at the state level). Note that you’ll also be paying taxes on dividends and interest as they accrue in the account, even if you don’t take that “income” out as current income to meet your spending needs.

Roth IRA – Withdrawals from your Roth IRA are completely tax-free, so long as you have fulfilled the 5-yr rule requirements (this rule is very complicated in many ways, but the simple rule is that your Roth account has to have been opened for five years prior to the withdrawal). Because of the estate friendly nature of Roth accounts and because there are no required minimum distributions (RMD) on Roth accounts, many clients will avoid tapping to this account type for as long as possible – sometimes never. However, tax-free income can be a tremendous strategic move to avoid other unintended consequences that can come from an increased Adjusted Gross Income (AGI) or Net Taxable Income. One such example is using tax-free income to keep your AGI below the IRMAA thresholds, which refers to premium surcharges that apply to your Medicare benefits if your income exceeds certain levels.

Health Savings Account – For those fortunate enough to have amassed funds in an HSA, this account can provide tax-free income, so long as the withdrawals are for qualified medical expenses. Most retirees have plenty of such expenses. Even if you don’t currently have any but you need tax-free income, you can also take an HSA withdrawal to reimburse yourself for previously unreimbursed medical expenses incurred anytime between the start of your HSA account and the current date, so long as you have documentation to support this withdrawal.

Note that you can always take withdrawals from an HSA for “non-qualified” expenses (defined as ANYTHING that isn’t “qualified”…including new shoes, travel, etc. – you name it!). The kicker here is that the withdrawal will be taxable as ordinary income, just like if you took money out of a pre-tax IRA. If you take this non-qualified withdrawal prior to age 65, you’ll have to pay a 20% early withdrawal penalty. This penalty is waived starting at age 65.

Social Security – In the vast majority of cases, 85% of your Social Security benefits are taxable as ordinary income. There are other circumstances, when your total income is lower, that either 0% or 50% of these benefits are taxable. This is rare for most clients we work with, as they have multiple taxable income streams beyond just Social Security, so you should plan for 85%. However, if Social Security is your only taxable income source, keep these lower rates in mind, as they may influence your decision making around things like Roth conversions, IRA distributions, capital gains realization, etc.

Annuities – Taxation of annuity payments is a mixed bag. In the case of a non-qualified annuity, portions, sometimes all, of a payment may be taxable as ordinary income (any portion drawn from growth of principal in the annuity account). Once the payments begin drawing on principal itself (meaning, the amount you contributed), that portion is non-taxable. If the annuity is held within a qualified pre-tax retirement account, the entire distribution will always be taxable as ordinary income. Learn more here.

Rental income – Whether you are an active or passive real estate investor, you may earn income from rentals in retirement. If you do, this income is taxable as ordinary income. However, unlike many other sources of retirement income, there are numerous ways to offset this taxable income, including through expenses related to the rental and depreciation. The exact mechanics of rental income and taxation are beyond the scope of this write-up, but we are happy to discuss with you at any time. 

Pensions – If you are fortunate enough to have a pension (a rarity these days), this income is generally taxable as ordinary income. 

Loan Interest income – Many retirees, especially those of significant means, will choose to become a lender in retirement, such as helping their kids purchase a home. Interest income earned from such loans is taxable as ordinary income.

Pre-tax retirement accounts (Traditional IRA / 401(k)) – Withdrawals from these accounts are taxable as ordinary income. Think of it as receiving a paycheck, just without incurring Social Security and Medicare (FICA) taxes. This can deter some clients from wanting to take withdrawals from these accounts. However, keep in mind two things here:

  1. Required minimum distributions do apply (starting now at ages 73-75, depending on your birth year), so you have to eventually take some funds, even if you don’t need or want them (though we’ll look in a second at a way to avoid taxation of these withdrawals).
  2. Pre-tax retirement accounts are generally an unfavorable asset to inherit, as they are now (as of 2020) subject to the 10-yr rule, meaning the entire account must be distributed by the end of the 10th year following the death of the account owner. There are more lenient and more stringent exceptions to this, so please consult with us and/or your tax professional for further guidance. This reality leads some to want to spend down their pre-tax accounts for the sake of leaving more advantageous assets to their heirs.

Note that you can avoid taxation of all or part of your IRA distribution by using a feature called a “Qualified Charitable Distribution” starting at age 70-1/2 or by using IRA assets to fund a Charitable Remainder Trust (details on this are beyond the scope of this write-up).

Life insurance benefits – If they come along, life insurance benefits are non-taxable (but are included in the value of the estate, so they may be subject to estate taxation). If they are substantial, they will likely get funneled into cash accounts and/or brokerage accounts, taking us back up to the top of this list.

LET'S WRAP THIS UP!

As you can see, not only are there a lot of ways to generate income in retirement, but thinking through taxation of these income streams can be complex. We hope this is a useful guide to help you begin thinking about and understanding this part of retirement planning. For those in retirement, perhaps this will save you a bit at tax time next year and help you stretch your resources to better meet your long-term needs. For those nowhere near retirement, perhaps this will help you think about ways you want to save towards generating retirement income that will pay out many years from now. Either way, as always, we welcome your questions and the opportunity to assist you in creating a retirement income plan that best meets your specific needs.

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