How Are Retirement Benefits Taxed?
If you're getting ready to retire, you may be curious about whether you'll have to keep paying taxes. Whether you'll have to pay taxes on retirement income depends upon the type of retirement benefits you're receiving and how the accounts were funded. Pensions, annuities, Social Security benefits, IRA distributions and 401(k) distributions are all taxed at ordinary income rates, but only to the extent that they're actually taxable.
Retirement benefits may or may not be taxable income depending upon the type of benefits they are. If your retirement is considered taxable income, you'll pay taxes on it at ordinary income tax rates, just as if it were income from a job.
Types of Retirement Income
Retirement benefits come in many varieties, including 401(k) accounts, IRAs, Social Security, pensions and annuities. Some people also save for retirement using other investments, such as CDs, savings accounts, money market accounts, stocks and bonds. Most retirement money is taxable at the ordinary income rates; however, income from stocks may be taxed at the lower long-term capital gains rate, depending on how long you've held them.
Contributions to Retirement Accounts: Pre-Tax or Post-Tax
Many retirement accounts are funded by contributions you make from each paycheck, and those contributions sit in an interest-bearing account and earn interest over the decades as you work. Contributions can be made pre-tax or post-tax. Pre-tax means that the money comes out of your pay before your taxes come out. This is beneficial because it reduces your taxable income for the year. However, it means that when you start getting that money paid back to you when you retire, you'll have to pay taxes on it then, plus taxes on the interest earned.
These types of counts are therefore called "tax-deferred" because you're not avoiding paying the tax but delaying it. If your retirement contributions come out of your paycheck after your taxes, these are post-tax contributions, and when they're distributed back to you at retirement, you don't pay tax on them because you already did. You only pay tax on the interest you earned over the years.
Examples of Pre-Tax and Post-Tax Contributions
If you have a tax-deferred retirement account like a 401(k), your contributions are taken out of your paycheck before taxes. For example, if you make $1,000 per month and contribute 5 percent to a 401(k), your monthly contribution will be $50. Your employer will then deduct taxes from your check based upon income of $950 instead of $1,000. When you retire, you'll be taxed on any distributions from your 401(k), because you never paid taxes on any of it.
However, if you have a post-tax retirement account like a Roth IRA, in the same scenario, your employer will deduct taxes from your check first, based on $1,000 in gross income, and then take out your contribution. So if you make $1,000 per month and your employer takes out $300 in taxes, you'll then contribute 5 percent of $700, or $35. When you receive distributions, you'll only be taxed to the extent of the interest earned, because you already paid tax on the principal.
Tax on Pension Income
Pensions are private retirement accounts created and funded by your employer. The money held in a pension account is composed of two things: the amounts contributed by you or your employer, and the interest earned on those funds. When you start getting your pension checks, you'll be taxed on the amount to the extent that it was contributed by your employer or that it is interest earned on the principal. If you contributed money to the pension, you'll be taxed on that amount as well, if your contributions came from pre-tax earnings and not post-tax. If you didn't make any contributions to the pension at all and the entire pension is funded by your employer, the whole thing is taxable.
States That Don't Tax Pensions
Every state has its own tax system and tax laws, separate and distinct from federal taxes. Some states don't have their own separate income tax at all; these are Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. Although you pay federal income tax if you live in these states, you don't pay tax on any of your income to the state, including pensions and other retirement income. You'll still have to pay the federal government any taxes owed.
States that don't tax pensions at all even though they have a state income tax are Illinois, Mississippi, New Hampshire, Pennsylvania and Tennessee. Several other states exempt only certain types of pensions, such as military pensions.
Tax on Distributions from Annuities
An annuity is a retirement vehicle you can buy either by yourself or through your employer. To be an annuity, the contract must require you to make periodic payments for more than one year. There are several types of annuities with complicated sets of rules, but generally, if you buy an annuity and receive retirement income from it, you're only taxed on what it earns. If you contribute $300,000 to the annuity and end up earning interest in the amount of $5,000, when you receive distributions, you'll only have to pay taxes on the $5,000 in interest. However, if you funded the annuity with pre-tax funds, you'll need to pay taxes on everything.
Tax on IRA Distributions
The most common types of IRAs are traditional IRAs and Roth IRAs. Traditional IRAs are funded pre-tax, while Roth IRAs are funded post-tax. Any distributions you receive from a traditional IRA will be taxed in full, just like any other tax-deferred retirement account. Distributions from a Roth IRA will only be taxed to the extent of interest earned.
Tax on 401(k) Distributions
401(k) accounts are usually tax-deferred accounts, although you may have a Roth 401(k) account through your employer if you're below certain income requirements. Most 401(k) accounts are funded by pre-tax contributions and employer matching, so when you receive your distributions at retirement, you have to pay tax on the whole thing.
Early Withdrawal Penalties for Tax-Deferred Retirement Accounts
Tax-deferred retirement accounts cannot be touched until you reach the age of 59 1/2. If you want to take money out of your 401(k), pension, tax-deferred annuity or traditional IRA before that, you'll have to pay the taxes on the withdrawal, plus a 10 percent tax penalty, barring certain exceptions to this rule. If you have a 401(k) that permits you to take loans, you can borrow money from the account and pay it back with interest, and you won't be assessed a penalty. You may also be able to avoid the penalty if you become permanently and totally disabled before you reach retirement age and need the money sooner because you can't work anymore.
Tax on Social Security Benefits
Social Security benefits are only taxable to a certain extent, and only if you make a certain amount of money from other sources. If you have no income other than Social Security, you will not have to pay taxes on it. However, if you have other income sources, such as from other retirement accounts or from a job, you may have to pay taxes on your Social Security benefits. If you're single and you make less than $25,000 from other sources, your Social Security benefits are not taxable; if you make between $25,000 and $34,000 in other income, half of your benefits will be taxable. If you make more than $34,000 in other income, you could be taxed on up to 85 percent of your Social Security benefits.
For example, if you're single and you receive $1,000 per month in Social Security benefits, but you also make $30,000 per year in 401(k) distributions, you'll have to pay taxes on $500 of your Social Security benefits every month.
- IRS: Topic Number 410 - Pensions and Annuities
- Kiplinger: How 6 Types of Retirement Income Are Taxed
- Washington Post: You May Be Surprised What Retirement Income is Taxed and What Isn’t
- Social Security Administration: Benefits Planner - Income Taxes And Your Social Security Benefit
- IRS: Publication 575 (2017), Pension and Annuity Income
- IRS: Publication 915 (2017), Social Security and Equivalent Railroad Retirement Benefits
- IRS: Publication 525 (2017), Taxable and Nontaxable Income
- IRS: Publication 590-B (2017), Distributions from Individual Retirement Arrangements (IRAs)
- IRS: Publication 554 (2017), Tax Guide for Seniors
- Forbes: Senior Specials: 14 States With Retirement Income Tax Breaks
- The Motley Fool: 37 States that Don't Tax Social Security Benefits
- Bankrate: Is a State with No Income Tax Better or Worse?
Rebecca K. McDowell is an attorney focusing on creditor and debtor law. She has a B.A. in English and a J.D. She has written finance and tax articles for Pocketsense and eHow.