Whether you are retired or soon-to-be, understanding the rules about paying taxes on your retirement income can help you avoid complications at tax time. That's why it's important that you work with tax and financial professionals to plan ahead. Here is a brief overview of the tax rules governing retirement income.
About one third of people who receive Social Security have to pay income taxes on a portion of their benefits. The taxability of Social Security retirement benefits depends on income -- specially defined for this purpose as your adjusted gross income (with certain modifications) plus tax-exempt interest and half of the Social Security benefits you received during the year.
For instance, if you are a single retiree with income between $25,000 and $34,000 or a married couple (filing jointly) with income between $32,000 and $44,000, you will be taxed on up to 50% of your Social Security benefits. For individuals with income over $34,000 and married couples with income over $44,000, up to 85% of benefits are taxable.
Once you start to make withdrawals from your traditional individual retirement account (IRA), 401(k), or other retirement plan, you'll have to pay income taxes on previously tax-deferred contributions and on investment earnings.
The IRS generally requires that you begin taking annual required minimum distributions (RMDs) from your traditional IRAs and retirement plan accounts when you reach age 72. The first RMD can be delayed until April 1 of the year following the year in which you turn 72. However, if you choose to do this, remember that you will also have to take a second RMD by December 31 of the year. Failure to take an RMD can trigger an additional 50% tax on the amount you should have withdrawn but didn't. This age was increased from 70½, effective January 1, 2020. Account holders who turned 70½ before that date are subject to the old rules.
Annuity payments generally are composed of two parts: the return of the investment, which is nontaxable, and interest, which is taxable. Other amounts, such as withdrawals and dividends, are taxable to the extent they exceed the contract's cost.