How To Plan for Taxes On Retirement Income

Summary: Going into retirement, it’s important to know how much taxes on retirement income you’ll have to pay and what factors may impact your tax liability.

Throughout your work life, you gradually build a nest egg that you can rely on in retirement. Contributing to a retirement account helps you save for the future and can also lower your taxable income in the present. However, taxes on those contributions are, in most cases, only deferred, and you will most likely end up paying taxes on that income in retirement.

Understanding the powerful shadow that taxes can cast on your retirement income can spur you into tax-efficient planning. Let’s delve into the impacts taxes have on retirement income, the types of retirement income and their tax implications, variations in tax rates (state and federal), and finally, the strategies that can help you minimize taxes and maximize your retirement income.

Understanding taxes on retirement income

Retirement income can come from various sources, such as Social Security benefits, 401(k)s or IRA accounts, pensions, and investment income. And the federal tax implications on the different types of retirement income also vary. The key is to choose tax-free or tax-efficient accounts that reduce your retirement income taxes and extend the longevity of your savings.

Types of retirement income and their tax implications

There are various types of retirement income streams, and each has its own tax implications. Consider working with a financial professional to help you assess the different retirement plans to see what works best for you.

1. Social Security benefits

When you start taking your Social Security benefits, you must pay taxes on that income. Social Security benefits are subject to federal income tax, and depending on your income level, up to 85% of your benefits may be taxable.

Social Security benefits may also be subject to state taxes, depending on your state. As of 2024, there are nine states that tax Social Security benefits: Colorado, Connecticut, Kansas, Minnesota, Montana, New Mexico, Rhode Island, Utah and Vermont.

2. Traditional 401(k)s and IRAs

Contributing to a tax-deferred retirement plan such as a traditional 401(k) or IRA reduces your taxable income while you’re working, but you do pay taxes at a later date. When you start withdrawing from these accounts in retirement, the withdrawals are considered ordinary income and are subject to federal income tax.

Once you reach age 73, if you are no longer working, the IRS requires you to take required minimum distributions (RMDs) from your traditional retirement accounts. If you don’t, you could be charged a penalty.

3. Roth Accounts

Roth 401(k)s and Roth IRAs are different from traditional retirement accounts because contributions to these accounts are made with after-tax dollars. Therefore, Roth IRAs can be considered tax free retirement accounts at the time of withdrawal. Qualified withdrawals from Roth IRAs in retirement are not taxable as long as certain conditions are met. Roth IRAs also aren’t subject to RMDs, but Roth 401(k)s are.

4. Pensions

Pension payments are taxed as ordinary income on the federal level and may also be subject to state taxes, depending on where you live. Some states that don’t tax pension income include Alabama, Hawaii, Illinois, Iowa, Mississippi, and Pennsylvania. The good thing is even if you live outside these states, not all of your pension income will attract tax. Check with the state’s revenue agency or a tax professional to ascertain this.

5. Investments

Investment income, such as capital gains, interest, and dividends, is subject to different tax rates based on your income and the type of investment. For example, long-term capital gains (held for more than one year) are taxed at a lower rate than short-term capital gains. Taxes on investment income apply regardless of whether you are retired or still employed. All investing involves risk. Educate yourself about the market, interest rates, inflation and credit risks associated with investments.

Using a retirement income calculator

A retirement income tax calculator is a valuable tool for estimating your tax obligations during retirement and projecting your monthly income after taxes. The calculator considers various factors, such as your retirement income sources, deductions, exemptions, and tax brackets, to estimate your tax liability.

Using a retirement income tax calculator can take your financial planning up by several notches — by exploring scenarios, aiding decisions on retirement income sources and helping you with smart tax moves to avoid surprises at filing.

Taxes on retirement income by state

When estimating the value of your taxable retirement income, it’s important to factor in state taxes, as these vary depending on where you reside. Some states don’t impose taxes on Social Security benefits, pensions, 401(k) or IRA distributions, while others do.

States with the highest and lowest taxes on retirement income

You may choose warmer locales for your golden years, but don’t forget to consider low-tax options as well. Generally, when planning for your retirement, you want to avoid living in states with the highest tax rates on retirement income. Those states include:

• California
• Connecticut
• Minnesota
• Oregon
• Vermont

In the same vein, some states with the lowest tax rate on retirement income are:

• Alaska
• Florida
• Nevada
• South Dakota
• Texas
• Washington
• Wyoming

Tax strategies to help maximize retirement income

To minimize taxes on your retirement income, consider strategies that help ensure more financial security as you transition to your post-career life:

1. Diversify your retirement income sources

You may be able to reduce your overall tax liability by drawing from a mix of taxable and tax-free income sources, such as a traditional 401(k) and a Roth IRA.

2. Strategize the timing of your withdrawals

For years when you earn more in taxable income, like if you sell your home or through some stock and earn capital gains, take withdrawals from your Roth IRA rather than a traditional IRA or 401(k). Because Roth contributions are made after taxes, you won’t have to pay any additional taxes on withdrawals.

3. Consider putting your traditional retirement account funds in a Roth account

If you convert a traditional 401(k) or IRA to a Roth IRA, you will have to pay taxes in the year of the conversion. But, once that is done, your future withdrawals from the Roth IRA will be tax-free.

If you’re uncertain whether your retirement income is taxable, or what the applicable rate might be, it’s wise to consult a tax specialist. This will help you steer clear of potential IRS penalties or audits.

Simplifying the process

Effective retirement tax planning involves understanding the location of your assets and strategically managing the order of withdrawals from different accounts. Using tools such as retirement income tax calculators to factor in tax rates while implementing tax-efficient retirement withdrawal strategies can help minimize your tax liability and maximize your retirement income. For professional guidance, contact a Mutual of Omaha financial professional, who can help simplify the process for you and help you build a path to a more secure financial future.

FAQs

Q1: At what age do you stop paying taxes on retirement income?

There is no magical age where you can stop paying taxes on your retirement income. As long as you earn income from tax deferred retirement plans, you must pay taxes on those earnings. The same is true for taxes on Social Security benefits.

Q2: What is the 4% rule for retirement taxes?

The 4% rule for retirement withdrawals advises withdrawing 4% of your total retirement savings each year. For instance, if you have $1 million saved, your initial withdrawal would be $40,000. This amount is adjusted annually to keep pace with inflation.

Disclosures:

Registered Representatives offer securities through Mutual of Omaha Investor Services, Inc., Member FINRA/SIPC. Investment Advisor Representatives offer advisory services through Mutual of Omaha Investor Services, Inc.

Mutual of Omaha and its representatives do not provide tax and/or legal advice, and the information provided herein is general in nature and should not be considered tax and/or legal advice.

Not all Mutual of Omaha agents are registered representatives or financial advisors.