Retirement Taxes: Know the Rules

We’ve all heard it. There are three certainties in life: death, taxes and change. For retirees, there are two realties, which are change is inevitable and you’ll still have to pay taxes, even though you are no longer working. Taxes are generally the biggest expense in retirement, and retirees who receive retirement income often need every penny so their money will last as long as they will.

According to CBS News, it is estimated that Americans overpay taxes to the tune of $945 million each year. Being able to plan ahead can go a long way to keeping your taxes as low as possible in retirement. You'll need to understand how your retirement income will be taxed, so you can take the right approach to keep your tax bill low.

Retirement income can take many forms such as Social Security benefits, IRAs, pension distributions, annuities and other retirement plans. Did you know that income from these sources might all be taxed differently? Some may be taxed heavily and some partially or fully tax-free. Understanding how each of these is taxed can help minimize the taxes you pay when you are no longer working.

IRA Distributions

Distributions from your individual retirement account may be fully taxable, partially taxable, or completely tax-free depending on the type of IRA you have. If you have a deductible Traditional IRA, your distributions will be fully taxable. You contributed funds using tax-deductible dollars, and tax is deferred on both the contributions and the earnings until they are withdrawn. If you have any money that you put into a non-deductible Traditional IRA, your distributions will be partially taxable. A portion of your distribution represents a return of your non-deductible investment, and that portion is recovered tax-free.

Distributions from Roth IRAs are completely tax-free as long as you meet a couple of basic requirements.

401(k) Distributions

Distributions from your employer's 401(k) plan are fully taxable since the contributions excluded from your taxable income. Distributions from Roth 401(k) accounts are treated the same as Roth IRA distributions.

Pensions and Annuities

Your pension or annuity may be fully or partially taxable. If all contributions to the pension were tax-deferred, your distribution will be fully taxable. If you contributed some after-tax dollars to fund your plan, part of your distributions will be a tax-free recovery of your money, and the remainder will be taxable income.

Social Security Income

Last but not least, there are your Social Security benefits. Social Security may be completely tax-free or partially tax-free, depending on your total income.

You can go to the Social Security Administration or IRS website to find out the “trigger” amounts that could expose your Social Security income to taxation. You should also consider working with a tax advisor to get an idea of whether your retirement income will cause some of your Social Security benefits to be taxed.

The bottom line is that taxes are one of life’s certainties. It’s more than just knowing the rules; it’s having a plan to navigate the rules because it’s not about what you make but what you keep. Being informed on how your retirement income will be taxed is a good first step in minimizing your tax liability and having more money in retirement.