What Counts as Income in Retirement?

In retirement, the way your money is treated for tax purposes changes. Not all cash you receive is considered “income” by the Internal Revenue Service (IRS), and understanding this distinction is fundamental for financial management. The structure of your income streams determines your annual tax liability, so properly identifying taxable versus non-taxable funds allows for more accurate financial planning and can prevent unexpected tax bills.

Taxable Retirement Account Distributions

When you withdraw money from tax-deferred retirement accounts, the distributions are treated as ordinary income and taxed at your current federal rate. This rule applies to common plans like traditional 401(k)s, 403(b)s, 457(b)s, and traditional Individual Retirement Arrangements (IRAs).

The taxation of these distributions is based on the premise that you received a tax benefit when you initially contributed the money. For employer-sponsored plans like a 401(k), contributions are made on a pre-tax basis, which lowers your taxable income during your working years. Similarly, contributions to a traditional IRA are often tax-deductible.

Pension payments are also generally fully taxable as ordinary income. An exception exists if you made after-tax contributions to your pension plan. In that scenario, a portion of each payment is considered a return of your own previously taxed money, known as your “basis,” and that part is not taxed again.

A similar rule applies to non-deductible traditional IRAs. If you made contributions but did not take a tax deduction, those contributions represent your basis. When you take distributions, you will not owe tax on the portion of the withdrawal that represents a return of your after-tax contributions, but all earnings are taxable.

The IRS also mandates that you begin taking required minimum distributions (RMDs) from most tax-deferred accounts starting at age 73. The RMD amount is calculated based on your account balance and life expectancy. These mandatory withdrawals are fully taxable, and failing to take them can result in a significant tax penalty.

Tax-Advantaged and Non-Taxable Distributions

Several retirement funding sources can provide tax-free income, most notably Roth IRAs and Roth 401(k)s. Contributions to Roth accounts are made with after-tax dollars, so you paid taxes on the money before it went in. Because of this, qualified distributions, including all investment earnings, are completely tax-free at the federal level.

A distribution is considered “qualified” if two primary conditions are met. First, you must be at least 59 ½ years old. Second, the account must have been open for at least five years, a period that begins on the first day of the tax year for which you made your first contribution.

Another source of non-taxable funds is a Health Savings Account (HSA), which offers a unique triple tax advantage. Contributions are tax-deductible, the funds grow tax-deferred, and withdrawals are tax-free when used for qualified medical expenses. In retirement, an HSA can function as a dedicated, tax-free resource for paying for doctor visits, prescription drugs, and dental care.

If you withdraw funds from an HSA for non-medical purposes before age 65, the withdrawal is subject to both ordinary income tax and a 20% penalty. After age 65, the penalty no longer applies, but the withdrawal will still be taxed as ordinary income if not used for medical costs.

Proceeds from a reverse mortgage are also not considered taxable income. A reverse mortgage is a loan that allows homeowners aged 62 or older to convert home equity into cash. Because these payments are classified as loan proceeds rather than income, they are not subject to federal income tax.

Understanding Social Security Taxation

The taxation of Social Security benefits depends on your other income, which the IRS calculates using a formula for “provisional income.” To find your provisional income, you sum your modified adjusted gross income (MAGI), any nontaxable interest, and 50% of your total Social Security benefits for the year. MAGI includes income from sources like investment dividends and distributions from traditional retirement accounts.

The taxability of your benefits falls into one of three tiers based on this income. If your provisional income is below $25,000 for single filers or $32,000 for those married filing jointly, none of your Social Security benefits are taxable.

If your provisional income is between $25,000 and $34,000 (single) or $32,000 and $44,000 (joint), up to 50% of your benefits may be taxable.

Should your provisional income exceed the upper thresholds of $34,000 (single) or $44,000 (joint), up to 85% of your Social Security benefits will be subject to taxation. No more than 85% of your benefits can ever be taxed, regardless of how high your income is.

Investment and Other Earned Income

Retirement income is not limited to dedicated retirement accounts, as many retirees generate funds from investments and part-time work. Income from taxable brokerage accounts is a common source. Interest earned from bonds, certificates of deposit (CDs), and savings accounts is taxed as ordinary income.

A different set of rules applies to dividends and capital gains. Qualified dividends and profits from selling an asset held for more than one year (long-term capital gains) are taxed at preferential rates of 0%, 15%, or 20%, depending on your taxable income. If you held an asset for a year or less, the profit is a short-term capital gain and is taxed as ordinary income.

Rental income from real estate properties is another potential income stream. This income is taxable as ordinary income after you subtract relevant expenses, which can include mortgage interest, property taxes, maintenance costs, and depreciation.

Any income earned from part-time work is taxed as ordinary income and is also subject to FICA taxes for Social Security and Medicare. These taxes amount to 7.65% of your earnings, with 6.2% for Social Security on earnings up to an annual limit and 1.45% for Medicare with no income limit.

Special Financial Events in Retirement

During retirement, you may encounter one-time financial events with specific tax implications, such as the sale of a primary residence. The tax law provides a benefit for homeowners through the Section 121 exclusion. This rule allows an individual to exclude up to $250,000 of gain, and a married couple filing a joint return can exclude up to $500,000.

To qualify for this exclusion, you must meet both ownership and use tests. This means you must have owned the home and used it as your primary residence for at least two of the five years leading up to the sale. The two years do not have to be continuous.

Inheritances and gifts are generally not considered taxable income to the person who receives them. Any potential estate or gift tax is the responsibility of the person who gave the gift or their estate. The federal estate tax exemption is high, but it is scheduled to be reduced at the end of 2025.

Proceeds from a life insurance policy paid to a beneficiary due to the death of the insured are also not counted as taxable income. This allows the full benefit amount to be used by the recipient without creating a tax burden.