Will You Pay Taxes During Retirement?

If you've been proactive, you've saved for retirement through an individual retirement account (IRA) and 401(k) plan. And you know that you'll get additional income from Social Security or through a pension. But what does this all mean for your tax bill when you leave the workforce?

Your tax liability during retirement all comes down to a few important factors, notably your:

• Filing status
• Retirement income sources
• Total annual income

As such, your yearly tax bill will affect how much money you really have to pay for your day-to-day expenses.

Having said this, it’s important to understand how your retirement income will be taxed. This information can help you plan for your future if you're still working. And if you've already retired, you may need to account for additional sources so you don't run out of money. Understanding how taxes will affect your retirement income can help you consider ways to minimize your tax bill and maximize your retirement income.

How Is Social Security Taxed in Retirement?

There's a good chance that you won't owe taxes on Social Security if it's the only source of income you receive during retirement. That's because your income will be too low to be taxable. But if you have other sources of income, including otherwise tax-exempt interest income, a portion of your Social Security benefits may incur a tax bill.

More than half of Social Security beneficiaries pay some tax on their benefits. The percentage of families receiving Social Security benefits who have to pay income taxes on them was less than 10% in 1984 and more than 50% by 2015. This figure may rise to 56% between 2015 and 2050, according to the Social Security Administration (SSA).

The amount of your taxable Social Security benefits depends on your combined income or the sum of:

1. 50% of all your Social Security benefits for the year
2. The adjusted gross income (AGI), which is your total income minus adjustments to that income, such as deductions and exclusions
3. Tax-exempt interest income, such as interest received on municipal bonds

Common sources of gross income include wages, salaries, tips, interest, dividends, IRA/401(k) distributions, pensions, and annuities. Common adjustments to gross income include health savings account (HSA) contributions, deductions for IRA contributions, student loan interest deductions, and contributions to self-employed retirement plans.

The level of your combined income determines the taxable portion of your Social Security benefits. The following chart indicates the percentage of your Social Security benefits that will be subject to tax at different levels of combined income:

How Much Income Can a Retiree Receive Without Paying Taxes?

This depends on a couple of factors, including the source of income and the total amount you receive. You may get distributions from 401(k)s and IRAs, Social Security benefits, pension payments, and annuity income. Some people may also continue to earn income from work, as an employee, or through self-employment, even though they may have retired from their regular or long-term employment.

Unearned Income

Unearned income may be subject to income tax and different tax rules. Ultimately, a retiree’s tax liability depends on the tax bracket in which they fall:

• Distributions from a traditional IRA (for which you claimed deductions for your contributions) may be taxable depending on your total annual income
• Distributions from a 401(k) plan or other qualified retirement account funded with before-tax contributions are taxable
  

Both your income from these retirement plans and your earned income are taxed as ordinary income at rates from 10% to 37%. And if you have an employer-funded pension plan, that income is also taxable.

Distributions from plans funded using after-tax contributions are not taxed the same way as those funded with pretax dollars. Form 1099-R, which is sent to a taxpayer who made after-tax contributions to plans, reports both the gross amount distributed as well as the taxable amount.

IRAs, 401(k)s, and similar plans are required to make annual required minimum distributions (RMDs) to beneficiaries, beginning the year they turn 72 years of age. The RMD requirement was suspended for the 2020 tax year, in response to the pandemic, but was reinstated for 2021.

Income such as dividends, rents, and taxable interest from investments held outside IRAs, 401(k)s and similar plans are subject to tax at ordinary income rates of up to 37%. Capital gains rates apply to gains realized on the sale of investments. Long-term capital gains are taxed at low rates, ranging from a zero rate bracket to a rate of 20% for taxpayers with very high taxable incomes. 

Earned Income

While unearned income, such as income from pensions, IRAs, annuities, and other investments, is subject to income tax under rules that vary by the income’s source, earned income works a little differently. Any income you earn from regular employment and self-employment sources is subject to Social Security, Medicare, and income taxes.

If you receive Social Security benefits and continue to work and earn income, you will have to pay Social Security and Medicare taxes on that earned income. However, if your total income (the sum of your earned income, unearned income, and Social Security benefits) remains low enough, you will not owe federal income tax on it. If your AGI is equal to or less than the standard deduction for your filing status, your federal income tax liability likely is zero.

Standard Deductions for Retirees

The standard deductions for 2021 are used on tax returns filed in 2022. The standard deduction for 2021 is $12,550 for single taxpayers and married taxpayers filing separately, $25,100 for married taxpayers filing jointly, and $18,800 for heads of household. The standard deduction for married couples filing jointly increased for the 2022 tax year to $25,900, tp $12,950, and to $19,400 for heads of households.

Taxpayers who are 65 years of age or older (whether or not they are retired) are eligible for an extra standard deduction of $1,700 for 2021 ($1,750 in 2022) if they are single or heads of household (and not married or a surviving spouse) and an extra $1,350 for 2021 ($1,400 in 2022) per senior spouse if they are married filing jointly, married filing separately, or a qualified widow(er).

* If not a surviving spouse, otherwise $1,350 in 2021 and $1,400 in 2022.

If your taxable total income falls below these amounts, you won’t owe any taxes. You usually won’t even have to file a tax return (unless you are married filing separately), though you may want to anyway. Filing a return allows you to claim any credits for which you might be eligible, such as the tax credit for the elderly and disabled or the earned income credit. Filing a return also ensures that you receive any refund you may be owed.

Taxpayers who itemize deductions may not claim the standard deduction and bonus amounts. Recent increases in the standard deduction amounts mean the threshold at which older taxpayers benefit more from itemizing than taking the standard deduction is higher. These higher levels may affect your decisions about when to make charitable donations or pay other deductible expenses. You may be able to benefit from itemizing in some years if you can lump large itemizable expenses together so that they fall within a single tax year.

Tax Brackets for 2021 and 2022

Below, you'll find the tax rates and brackets based on filing status and income thresholds for both the 2021 and 2022 tax years.

Marginal tax rates for 2022 don't change but the level of taxable income that applies to each rate increases. The top rate of 37% will apply to income over $539,900 for individuals and heads of household and $647,850 for married couples who file jointly.

The Bottom Line

Will you pay taxes in retirement? Unless your taxable income falls at or below the standard deduction level every year, you probably will. How much you’ll pay is another story. There are many ways to help retirees minimize their tax burden. Strategies include timing distributions, bunching income, bunching deductions that can be itemized, and doing retirement account conversions.