How Does Federal Tax on Retirement Income Work?

Navigating the transition into retirement involves many financial adjustments, including how you handle federal income taxes. A steady paycheck with automatic tax withholding is often replaced by multiple income streams, each with its own set of tax rules. The tax implications for retirement income are not uniform and vary considerably depending on the source of the funds. Understanding these distinctions is necessary for accurate tax planning and avoiding unexpected liabilities.

Tax Treatment of Common Retirement Income Sources

Traditional Retirement Accounts

Distributions from traditional, pre-tax retirement accounts are a source of taxable income for many retirees. This includes funds from Traditional IRAs, 401(k)s, 403(b)s, and most pension plans. Because contributions were made with pre-tax dollars, which lowered your taxable income during your working years, the withdrawals are taxed as ordinary income.

An exception exists if you made any after-tax, or non-deductible, contributions to a traditional IRA. In that case, a portion of your withdrawal is a tax-free return of your contributions, calculated on a pro-rata basis using IRS Form 8606.

Roth Retirement Accounts

In contrast to traditional accounts, qualified distributions from Roth IRAs and Roth 401(k)s are entirely tax-free at the federal level. Contributions to Roth accounts are made with after-tax dollars. The benefit is that all investment earnings can also be withdrawn tax-free, provided certain conditions are met.

For a withdrawal to be a “qualified distribution,” two tests must be met. First, the account owner must be at least 59½ years old, disabled, or deceased. Second, at least five years must have passed since the owner first contributed to any Roth IRA or that specific Roth 401(k) plan.

Annuities

The taxation of annuity payments depends on whether the annuity was purchased with pre-tax or after-tax funds. If funded with pre-tax money, such as from a traditional 401(k) rollover, the entire payment is taxed as ordinary income. This is a qualified annuity.

For non-qualified annuities purchased with after-tax dollars, an “exclusion ratio” is used. This calculation separates each payment into a non-taxable return of your investment and taxable earnings. You do not pay tax again on your investment, but you do pay ordinary income tax on the growth.

Investment Income

Retirees often have earnings from taxable brokerage accounts, including interest, dividends, and capital gains. Interest income is taxed at ordinary income rates. Dividends can be “qualified,” taxed at lower long-term capital gains rates, or “non-qualified,” taxed as ordinary income.

Capital gains occur when an asset is sold for a profit. If the asset was held for more than one year, the profit is a long-term capital gain taxed at 0%, 15%, or 20%, depending on your taxable income. Gains on assets held for one year or less are short-term capital gains and are taxed at your ordinary income tax rate.

Calculating Tax on Social Security Benefits

A portion of your Social Security benefits may be subject to federal tax, depending on your “provisional income.” To calculate this, add your adjusted gross income (AGI), any nontaxable interest, and 50% of your total Social Security benefits for the year. Your AGI includes income from wages, traditional retirement account withdrawals, and investments.

The total is then compared to IRS income thresholds. For an individual filer, if provisional income is between $25,000 and $34,000, up to 50% of benefits may be taxable. If it exceeds $34,000, up to 85% may be taxable.

For those married filing jointly, the 50% taxable range is for provisional income between $32,000 and $44,000. If joint income exceeds $44,000, up to 85% of benefits may be taxable. For example, a married couple with a $35,000 AGI and $20,000 in Social Security has a provisional income of $45,000 ($35,000 + $10,000). Since this is above the $44,000 threshold, a portion of their benefits will be taxed.

Understanding Required Minimum Distributions

The federal government requires retirees to take a Required Minimum Distribution (RMD) from most tax-deferred retirement accounts. This rule is designed to prevent individuals from deferring taxes indefinitely on these funds. RMDs apply to traditional plans like Traditional IRAs, 401(k)s, and 403(b)s.

Roth IRAs are exempt from RMDs for the original owner, and as of 2024, Roth 401(k)s are also exempt. The age to begin RMDs is 73 for individuals who turn 72 after December 31, 2022. The RMD age will increase to 75 starting in 2033. The withdrawn amount is included in your taxable income for the year.

Failing to take the full RMD by the December 31 deadline results in a penalty of 25% of the amount that should have been withdrawn. This penalty can be reduced to 10% if the error is corrected within two years.

Key Tax Deductions and Credits for Retirees

Higher Standard Deduction

Taxpayers age 65 or older are entitled to a higher standard deduction, which reduces their adjusted gross income. For the 2025 tax year, a single filer who is 65 or older can add $2,000 to their standard deduction. For married couples filing jointly, each spouse age 65 or older can add an extra $1,600. If both spouses meet the age requirement, their standard deduction increases by $3,200.

Credit for the Elderly or Disabled

A nonrefundable tax credit is also available for certain lower-income individuals who are either age 65 or older or who are retired on permanent and total disability. Unlike a deduction, which reduces your taxable income, a credit directly reduces your tax bill dollar-for-dollar. This credit is nonrefundable, meaning it can reduce your tax liability to zero, but you cannot get any of it back as a refund.

Eligibility is determined by strict income limits based on your AGI and nontaxable Social Security or pension income. For example, a single individual generally cannot claim the credit if their AGI is $17,500 or more. The calculation is completed using Schedule R.

Methods for Paying Federal Tax in Retirement

Tax Withholding

One way to pay federal income tax in retirement is through voluntary withholding. You can request that payers of retirement income withhold a set amount for taxes before sending you the payment. This method helps manage your tax obligation throughout the year and can prevent a large bill when you file your annual return.

Use Form W-4P for pension and annuity payments to instruct the payer on how much to withhold. For Social Security, you can submit Form W-4V to request a flat withholding rate of 7%, 10%, 12%, or 22%.

Estimated Tax Payments

If you have income not subject to withholding, such as from investments, you may need to make estimated tax payments. This system requires you to pay tax in four quarterly installments using Form 1040-ES. You must make estimated tax payments if you expect to owe at least $1,000 in tax for the year after subtracting withholding and credits.

The payments are due on April 15, June 15, September 15, and January 15 of the following year. Not paying enough tax throughout the year can result in an underpayment penalty.