Taxes in retirement: A comprehensive guide

Planning for retirement involves more than just saving money—you need to understand how taxes will impact those savings. The amount of taxes you pay on your income can significantly affect your retirement income; how much money you will have to live on and how long your savings will last.

Whether you're just starting to save for retirement or are nearing retirement age, this guide will help you understand how to manage your retirement income in a tax-efficient manner, so you can make the most out of your hard-earned savings.

All income, including your retirement income, can be put into one of three tax buckets. Each has different implications about when you pay the taxes owed on the dollars you've earned, whether that income is from a job or investment interest and gains.

Tax now

Pay taxes upfront.

Tax later

Pay taxes upon withdrawal.

Tax never

No tax liability.

Taxable income is money that's taxed in the year it's received, such as wages, business income and rent or royalties. It also includes investment income in taxable accounts such as:

• Checking and savings accounts.
• Certificates of deposit (CDs).
• Securities in brokerage accounts.
  

These kinds of accounts are funded with dollars you pay taxes on. Then you pay additional taxes as interest, dividends and capital gains are earned. They don't have any special tax treatment.

The tax later bucket consists of money received from:

• Pensions.
• Annuities.
• Retirement accounts like traditional IRAs, 401(k)s, 403(b)s & 457(b)s.
  

The tax advantage is that you don't pay income tax on the money when you contribute it, and you instead pay when you make withdrawals—ideally waiting to do so until retirement so you don't face early withdrawal penalties. Saving for retirement in tax-deferred accounts can help reduce your taxable income, keeping you in a lower tax bracket during your working years and allowing your investments to grow tax-deferred until you withdraw them.

Tax-free income comes from the earnings in:

• Roth IRAs and Roth 401(k)s.
• Municipal bonds.
• Cash value life insurance.
  

You pay taxes on your contributions and purchases to fund these savings and investment tools at the start, but you'll avoid tax on the principal and any growth when you withdraw it—as long as you meet certain conditions. Saving for retirement in nontaxable accounts won't lower your tax liability in your working years, but the tax efficiency plays out in your retirement when you can access tax-free income.

You've probably heard of portfolio diversification, or spreading your investments across a mix of different assets or securities to reduce risk. Income tax diversification involves saving in various taxable, tax-deferred and tax-never accounts.

Many people assume they'll be in a lower tax bracket in retirement, but that's not always the case. You may have fewer deductions in retirement—especially if you've paid off your mortgage and no longer have children to claim as dependents.

Tax diversification can help you balance your income sources, stay in a lower tax bracket and take advantage of tax credits and deductions.

Taking advantage of tax credits and deductions and knowing which bracket you'll be in now vs. later is another way to be tax-efficient with your money leading up to, and throughout, your retirement. Here's a review of what these terms mean.

Tax credits are dollar-for-dollar amounts that can be taken off your calculated tax bill. For example, if you determine you owe $10,000 in taxes but have a $1,000 tax credit available to claim, you'll only have to pay $9,000.

Some common tax credits include:

• Child and dependent care credit.
• Earned income tax credit.
• Education credits, including the lifetime learning credit and the American Opportunity Tax Credit.
• Saver's credit.
• Credit for the elderly or disabled.

Deductions reduce your taxable income, which results in a smaller tax calculation. For example, if you're in the 22% tax bracket, a $1,000 tax deduction will reduce your tax bill by roughly $220.

Common deductions include:

• IRA contributions.
• Pre-tax contributions to a 401(k), 403(b) and most 457(b)s.
• Health savings account (HSA) contributions.
• Charitable donations.
• State and local taxes.
• Mortgage interest.
• Business expenses.
• Medical expenses.
• Additional standard deduction for seniors 65 and older.
  

The U.S. tax system is progressive, meaning your income is taxed at higher rates as it increases. It's important to be aware of the level you're at currently and where you expect to be in retirement so you can decide which tax buckets may be a better move for tax efficiency. Plus, certain tax credits and deductions are only available to people with adjusted gross income (AGI) under certain limits. Deductions in particular may bring you to a lower tax bracket, which means you'll be taxed at a lower rate.

There are seven tax brackets at these marginal tax rates for single filers:

• 10% for taxable incomes of $11,600 or less
• 12% for taxable incomes $11,601 to $47,150
• 22% for taxable incomes $47,151 to $100,525
• 24% for taxable incomes $100,526 to $191,950
• 32% for taxable incomes $191,951 to $243,725
• 35% for taxable incomes $243,726 to $609,350
• 37% for taxable incomes $609,351 or greater

• 10% for taxable incomes $23,200 or less
• 12% for taxable incomes $23,201 to $94,300
• 22% for taxable incomes $94,301 to $201,050
• 24% for taxable incomes $201,051 to $383,900
• 32% for taxable incomes $383,901 to $487,450
• 35% for taxable incomes $487,451 to $731,200
• 37% for taxable incomes $731,201 or greater

Significant life changes in retirement, such as the death of a spouse, can affect your taxes.

When a spouse dies, the surviving spouse can file married, jointly in the year of their death (unless they remarry). However, after that year, the surviving spouse becomes a single filer, which means they may move into a higher tax bracket and lose the higher standard deduction available to joint filers.

State taxes also can affect your retirement income. Some states have no income tax, some don't tax Social Security and pension income, and others tax retirement income at varying rates. Consider the state you live in (or plan to retire in), as it can have a substantial effect on your overall tax burden.

Consulting with a tax professional can help you understand how these changes impact your taxes as you work toward a financially stable retirement.

Related: If your spouse dies, do you get their Social Security benefits?

Over 65? Don't miss out on these retirement tax breaks

Discover how you can keep more of your hard-earned money in retirement with smart tax strategies tailored to seniors. From higher deductions to special credits, you might be surprised at the tax breaks you may have overlooked.

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When you retire and start depending on your savings, investments and benefits to support you and your loved ones, it's crucial to know how these new income sources will be taxed. For instance, taxes automatically are withheld from some retirement income sources but not from others.

Here's a look at how common retirement accounts and income sources are taxed.

Depending on your total income, up to 85% of your Social Security benefits may be subject to federal income tax.

The exact percentage depends on your combined income. This is the sum of half the Social Security benefits you received during the tax year plus other income earned, such as pensions, wages, dividends, interest (including tax-free bond interest) and capital gains.

You can choose to have federal taxes withheld from your Social Security benefits at a rate of 7%, 10%, 12% or 22%.

Social Security income taxes: How much will you owe?

Traditional IRAs, 401(k)s and other qualified retirement accounts are tax-deferred. Contributions typically are deductible from your income in the year they were made, while withdrawals are taxed as ordinary income in the year they're taken.

With these accounts, you have to start taking required minimum distributions (RMDs) at a certain age. Failing to take RMDs can lead to hefty penalties—25% of the amount that should have been withdrawn.

If you were born:

• 1950 or earlier: RMDs start at age 72.
• Between 1951 and 1959: RMDs start at age 73.
• 1960 or later: RMDs start at age 75.

Taxes generally aren't automatically withheld from IRA distributions unless you request it, but many 401(k) plans require a mandatory 20% federal tax withholding on all distributions.

Pension income is typically taxed as ordinary income. Some pensions may offer lump-sum distributions, which can be subject to different tax rules.

When you purchase a deferred annuity, its value grows during an accumulation phase. That growth is tax-deferred, so you don't owe taxes on earnings or interest during the accumulation phase.

The tax treatment of your payouts depends on whether you have a qualified annuity or nonqualified annuity.

Income tax is generally withheld from pension and annuity withdrawals. You can adjust the withholding amount based on your estimated tax liability.

Learn more about how annuities can provide guaranteed retirement income

Interest, dividends and capital gains from nonretirement investment accounts are taxable income. Long-term capital gains (from assets held over a year) are taxed at a lower rate than ordinary income—between 0% and 20%, depending on your filing status and total taxable income.

Short-term capital gains (from assets held one year or less) are taxed at your ordinary income tax rate.

You can lower your capital gains taxes by timing your sales right to take advantage of lower long-term capital gains rates and tax-loss harvesting.

Tax-free retirement income sources allow you to withdraw funds without paying income taxes. Here are some common tax-never retirement income sources:

Roth IRAs are funded with after-tax dollars, meaning you've already paid taxes on the money you contribute. Qualified withdrawals, including earnings, are free from tax if the account is at least five years old and you are older than 59½. Other qualifications may apply.

Roth IRAs also don't have RMDs during the account holder's lifetime, allowing your investments to grow for as long as you want.

However, Roth IRAs aren't available to everyone. If your modified adjusted gross income (MAGI) is above a certain threshold, your ability to contribute to a Roth IRA may be limited or eliminated.¹ If this applies to you, check out these alternatives.

Roth 401(k)s and other Roth retirement plans, including Roth 403(b)s and Roth 457(b)s, are funded with after-tax contributions. Qualified distributions from Roth 401(k)s and similar plans are not taxable, provided you've had the account for at least five years and are older than 59½.

One benefit of a Roth 401(k) is there's no income limit to participate. However, if your employer matches contributions to your plan, it's essential to recognize that those matching contributions are made to a traditional 401(k) account—they'll be subject to taxes upon withdrawal.

Municipal bonds, often called "munis," are issued by state and local governments.

Interest income from municipal bonds is generally exempt from federal income tax. If you buy bonds issued by your home state, the interest also may be exempt from state income taxes.

While the interest is tax-exempt, any capital gains from selling municipal bonds are taxable.

Permanent life insurance contracts, such as whole life or universal life insurance, provide a death benefit to your heirs and also can accumulate cash value that you can access during your lifetime.

The death benefit paid to your heirs is generally tax-free. You can borrow against your contract's cash value without paying taxes.² However, if you surrender the contract, any gains over the premiums paid are taxable income.

HSAs are tax-advantaged accounts that allow you to deposit pre-tax income to save for future medical expenses. They're "triple-tax-advantaged" accounts because they offer tax-free:

1. Contributions: Contributions to an HSA are tax-deductible or pre-tax if made through payroll deductions.
2. Earnings: The funds in the HSA grow tax-free.
3. Withdrawals: Withdrawals for qualified medical expenses are always nontaxable. After age 65, withdrawals for nonmedical expenses are subject to ordinary income tax rates, but you won't have to pay the 20% penalty for taking a nonqualified withdrawal.

You also can use an HSA to save for retirement. A study from the Center for Retirement Research at Boston College found that from age 65, the average household will spend $67,000 on out-of-pocket health care costs over the remainder of their lifetimes. Of course, that figure is the average—10% percent will spend a whopping $138,000 or more.

Incorporating HSA savings into your retirement plan can supplement your retirement income without increasing your tax bill.

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Creating a Roth IRA can make a big difference in your retirement savings. All future earnings are sheltered from taxes under current tax laws. If you meet a qualifying distribution event, a Roth IRA can provide truly tax-free growth potential.

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While you may withhold taxes from some sources of retirement income, it might not be enough to cover your actual tax liability.

Here are some tips to help you account for the gap:

• Estimate your total taxable income: Calculate your expected taxable income from all sources, including Social Security benefits, retirement accounts and investments.
• Determine your tax bracket: Based on your total estimated income, determine your federal and state tax brackets to get an idea of your overall tax liability.
• Adjust withholding or make estimated payments: Adjust the withholding on your Social Security, pension and other income sources as needed. If withholding isn't enough, make quarterly estimated tax payments to avoid penalties and interest.
• Consult a tax professional: Work with a tax advisor to review your retirement income plan and ensure you meet your tax obligations efficiently.

Keeping your taxable income as low as possible in retirement requires careful planning and strategic moves. Any significant increase in your income can push you into a higher tax bracket, potentially affecting your Social Security retirement benefits and Medicare premiums.

Here are key strategies to help you stay in a lower tax bracket.

Maximizing your retirement contributions will reduce your taxable income now.

Contributions to traditional IRAs and 401(k)s are generally tax-deductible, lowering your taxable income—which is particularly beneficial if you're still working and earning income.

If you are 50 or older, don't forget about additional catch-up contributions to your retirement accounts.

Once you start taking withdrawals in retirement, the goal is to draw from your different income buckets in a way that keeps you in the lowest tax bracket possible.

• Retirement withdrawal strategies: If your taxable income is high in a given tax year—for example, if you sold a big investment—you may want to pull more from a "tax-never" account. If your taxable income is low, this can be a good opportunity to make a Roth conversion or take more from taxable or tax-deferred accounts.

• The 4% rule: This popular rule of thumb suggests withdrawing no more than 4% of your total investment assets starting the first year of retirement. While guidelines can be helpful, it's essential to consider your unique financial situation and adjust as necessary.

• Systematic withdrawal plans: A systematic withdrawal plan is a structure of tapping into your retirement funds periodically to provide a predictable cash flow.

The right retirement withdrawal strategy for you depends on several factors, including your income needs, tax situation and the different tax treatments of your accounts. It's important to work with an advisor who can help you time withdrawals to your advantage.

Check out more common withdrawal strategies to help your savings last

Moving assets from tax-deferred to tax-free accounts can reduce your taxable income and keep you in a lower tax bracket in retirement.

Consider converting assets from a traditional IRA to a Roth IRA. While you'll pay tax on the converted amount now, future withdrawals from the Roth account will be tax-free. This is particularly advantageous if you expect tax rates to be higher in the future.

Between ages 59½ and 73 (or your RMD age), you can make withdrawals without penalties or required distributions. Taking withdrawals from taxable accounts and repurposing the funds into tax-exempt municipal bonds and life insurance can provide tax-deferred growth and the potential for income tax-free death benefits for heirs. With the potential sunsetting of the Tax Cuts and Jobs Act's lower tax brackets at the end of 2025, this is an opportunity for maximizing tax efficiency. If you wait until your RMD age, taxes on those RMDs may be higher than they are today.

Learn about potential changes with the sunset of the Tax Cuts & Jobs Act

Your income impacts how much you'll have to pay for Medicare. Higher income increases your Medicare Part B and Part D premiums. Roth conversions and other strategic moves at least two years prior to filing can help manage your modified adjusted gross income and lower premiums.

The taxation of your Social Security benefits depends on your income. Strategic withdrawals and Roth conversions prior to claiming Social Security benefits can help manage your combined income and reduce the taxable portion of your benefits.

Holistic planning is essential to bring all these pieces together. Working with a financial advisor can help you develop a comprehensive strategy covering all aspects of your retirement income and tax situation.

Charitable giving can be a powerful tool for reducing your tax burden while supporting causes you care about. By strategically planning your donations, you can maximize tax benefits while making a significant impact. Here are some tools and strategies to help you give efficiently.

Qualified charitable distributions (QCDs) allow people age 70½ or older to donate up to $105,000 annually directly from their IRA to a qualified charity. QCDs are not included in your taxable income, so they help reduce your overall tax burden. They also count toward your RMDs, making QCDs a tax-efficient way to meet these requirements while supporting your favorite charities.

Many people fail to benefit from their charitable deductions because they don't itemize—their itemized deductions aren't more than the standard deduction available for their filing status.

Charitable bunching, or bundling, involves combining multiple years of charitable contributions into one tax year to overcome the barrier to itemizing.

For example, if you usually donate $5,000 annually to your local food bank, you could donate $15,000 every three years instead. That $15,000 donation, combined with other itemized deductions like mortgage interest, state/local taxes and out-of-pocket medical expenses may give you a greater tax benefit than claiming the standard deduction.

Donor-advised funds (DAFs) allow you to contribute to a charitable fund, receive an immediate tax deduction and recommend grants to charities over time. You receive a tax deduction in the year you contribute to the DAF, even if the funds are disbursed to charities in future years.

DAFs allow you to decide which charities to support and when to make donations, allowing for strategic tax planning.

A charitable gift annuity is a contract between a donor and a charity in which the donor makes a significant donation in exchange for a lifetime stream of income. At the donor's death, the charity receives any remaining assets.

This can be a beneficial way to support your favorite charity while maintaining the financial security of receiving fixed-income payments for life. The donation provides a partial tax deduction at the time of the gift, and a portion of each annuity payment may be tax-free.

A charitable remainder trust (CRT) allows you to place assets in a trust, receive income for a specified period and donate the remaining assets to charity.

The benefits include:

• You or your beneficiaries can receive income from the trust for a set number of years or for life.
• You receive a partial tax deduction based on the present value of the remainder interest that will eventually go to charity, and the trust can sell appreciated assets without immediate capital gains tax.

Your financial advisor can help you choose the most tax-efficient charitable giving strategy for your financial circumstances and philanthropic goals.

Many retirees hope to pass on some of their wealth to loved ones, but leaving a legacy can be a complex process with significant tax ramifications. Your estate could owe taxes on property transfers when you die, which reduces the total value available to pass on to your heirs and beneficiaries.

The good news is that you can minimize the impact of estate taxes with thoughtful estate planning. Here are some strategies to discuss with your financial advisor and estate planning attorney.

• Use the estate tax exemption. The federal estate tax only applies to estates worth more than an inflation-adjusted amount. Proper planning can help ensure you make the most of this exemption, potentially doubling the exemption amount for married couples through portability.

• Give during your lifetime. You can give gifts up to the annual gift tax exemption to children, grandchildren and other loved ones each year without paying gift taxes or cutting into your lifetime exemption amount. This can significantly reduce the size of your taxable estate over time.

• Create an irrevocable trust. Placing assets in an irrevocable trust removes them from your taxable estate. Trusts also can provide asset protection and control over how and when your beneficiaries receive their inheritance.

You may want to make larger gifts to your loved ones than allowed under the annual gift tax exemption limit. In that case, you either can pay the gift tax on those gifts or allow them to reduce your lifetime estate tax exemption.

Any estate planning strategy also should take inheritance taxes into account. While the federal government doesn't impose an inheritance tax, some states do. The tax rate and exemption amounts vary by state, so it's essential to understand the rules in your state if you are leaving any bequests for your heirs.

Consulting with your estate planning attorney and financial advisor can help you identify the right estate planning strategies for your specific situation and goals.

Dive deeper into the differences between estate and inheritance taxes

Planning for taxes in retirement is crucial to ensuring financial security and maximizing the value of your savings. By understanding the types of retirement income, using tax-efficient strategies, and leveraging charitable giving and wealth transfer techniques, you can reduce your tax burden and enjoy a more secure retirement.