How Retirement Income is Taxed: The Basics

When you stop working, your income streams shift. Instead of a regular paycheck, you might rely on a mix of sources like Social Security, pensions, and withdrawals from retirement accounts. Each of these is treated differently by the tax system. Understanding these differences is the first step in managing your retirement taxes effectively.

Withdrawals from traditional retirement accounts, such as a 401(k), 403(b), or a traditional IRA, are generally taxed as ordinary income. This means they are taxed at your regular income tax rate, just like wages from a job. You deferred paying taxes on that money while you were working, and now that you are taking it out, the tax bill comes due. The amount you withdraw is added to your other income for the year to determine your tax bracket.

Pension payments are also typically taxed as ordinary income at the federal level. If you contributed to your pension with after-tax dollars, a portion of your payments might be tax-free. Your former employer or pension plan administrator will provide you with a Form 1099-R each year, which details how much of your pension is taxable.

Income from Roth IRAs or Roth 401(k)s is a welcome exception. Because you paid taxes on the money before you contributed it, qualified distributions from a Roth account are completely tax-free. This makes Roth accounts a powerful tool for creating a tax-free income stream in retirement.

Then there is Social Security. For many years, Social Security benefits were not taxed at all. However, laws passed in 1983 and 1993 made a portion of these benefits taxable for individuals with other sources of income. This is where things get more complex. Unlike a 401(k) withdrawal, which is fully taxable, your Social Security benefits may be 0%, 50%, or up to 85% taxable. The exact percentage depends on a special calculation based on your total income, which we will explain in detail next.