What the IRS Thinks of ‘Income’ in Retirement
Not all income is treated equally when it comes time to file taxes. Some sources of income are fully taxable, while other sources receive exemptions or favorable tax rates.
How the IRS classifies income can affect your Social Security taxes and Medicare premiums. Understanding the tax code and using it when planning financially can save you money. Here’s what you need to know.
Fully taxable sources of income
Your salary, tips, bonuses and other earnings from full-time, part-time or gig work are considered regular income, making them fully taxable. However, there are other sources of income that are also fully taxable, including traditional individual retirement accounts (IRA) and 401(k) withdrawals. That’s especially important to pay attention to when it’s time for required minimum distributions (RMDs), which require you to withdraw a percentage of your portfolio each year when you reach age 73.
Interest from a bond, bank account or certificate of deposit (CD) also counts as fully taxable income, although interest on municipal bonds is generally exempt from federal taxes, and sometimes state and local taxes, too.
Pensions are almost always treated as fully taxable income unless you have made after-tax contributions to your plan.
Less tax: Social Security
Up to 85% of Social Security benefits can be subject to federal income tax. Your benefits are not taxed by the federal government if your income is less than $25,000 a year ($32,000 for married couples filing jointly). Up to 50% tax if your income is between $25,000 and $34,000 ($32,000 to $44,000 for married couples) with 85% of your taxable benefits if your income exceeds $34,000 ($44,000 for married couples).
“Gross income” refers to your total adjusted gross income, tax-free income and a portion of your annual Social Security benefits.
Tax-free sources of income
Tax-free income streams can work wonders for your retirement plans and make it easier to keep track of rising expenses. Roth IRAs and Roth 401(k) plans are tax-free when you withdraw from those accounts since you fund them with after-tax dollars. It does not affect how much of your Social Security benefits are taxable, and they are not subject to RMDs.
As mentioned earlier, municipal bond interest has some tax exemptions, and you don’t have to report the life insurance payments you receive as the beneficiary. Health savings account (HSA) withdrawals for qualified medical expenses, gifts received and inherited Roth IRA withdrawals are also generally tax-free.
Review your salary
Getting a summary of your finances will help you assess your sources of income and how much of your Social Security benefits will be taxable. When listing sources of income, be sure to separate the tax treatment for each option.
There are ways to use smart tax planning and reduce your income, potentially reducing the amount of tax you pay on Social Security benefits. For example, a partial Roth conversion before retirement can help, since you won’t pay taxes when you withdraw from a Roth account.
