I Thought It Was Tax-Free: 7 Retirement Income Sources That Still Trigger Taxes
Retirement may change where you're getting your income, but it doesn’t necessarily end your relationship with the IRS. Social Security, retirement account withdrawals, pensions and even investments commonly described as “tax-free” can still trigger federal or state taxes.
As Gregory DuPont, JD, a certified financial planner (CFP) and founder of Advocate Wealth Solutions, put it, “The financial services industry may think in silos, but the tax code doesn't.”
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Here are retirement income sources that still trigger taxes.
1. Social Security Benefits
Social Security is not automatically tax-free. Logan Allec, a certified public accountant (CPA) and owner of Riverside CPA & Tax, said that up to 85% of benefits can become partially taxable once “combined income” exceeds $25,000 for single filers or $32,000 for married couples filing jointly.
"What catches people is that the trigger is often their own IRA or 401(k) withdrawal," DuPont said. "Pull an extra $20,000 for a new roof, and you may have just made a portion of your Social Security taxable that wasn't before.”
2. Traditional 401(k) and IRA Withdrawals
Money saved in traditional retirement accounts likely received favorable tax treatment on the way in, but not necessarily on the way out, according to Allec. He said traditional 401(k) and IRA withdrawals are usually taxed as ordinary income in retirement.
“Possible exceptions are if you made after-tax contributions to your traditional 401(k) or IRA, in which case a portion of your distribution may be tax-free,” he said. These withdrawals can also have a ripple effect by increasing combined income and potentially making more Social Security taxable.
3. Roth Withdrawals That Don't Meet the Rules
Roth accounts are thought to be tax-free on the way out, but retirees still need to meet the requirements for qualified distributions. Allec said that distributions can become taxable depending on the account holder’s age, and DuPont added that they can become taxable “if the five-year rule hasn't been satisfied, which trips up people who converted late.”
The five-year rule states that you must wait at least five years since January 1 of the tax year you made your first-ever contribution to any Roth IRA.
4. Pensions and Annuity Income
Pension payments are generally taxed as ordinary income, although retirees who made after-tax contributions may receive a portion of their payments tax-free, Allec said.
Annuities can be more complicated. Payments from a qualified annuity held inside a pre-tax account such as a traditional IRA are generally fully taxable, while for a non-qualified annuity funded with after-tax dollars, only the earnings portion is taxable, Allec said.
“Determining what ‘the earnings portion’ is for a non-qualified annuity can get complex and depends on the nature of the annuity contract,” he said.
5. Municipal Bond Interest
Municipal bonds are frequently described as tax-free, but Dupont called them “the sneakiest one” because while it’s federally tax-exempt, it still counts in the combined income calculation for Social Security taxation, and toward the income measure used for IRMAA.
“So 'tax-free' interest can raise your Medicare premiums and the tax on your benefits,” he said.
Allec said that tax-exempt interest is included when determining combined income for Social Security, while some private activity bond interest can factor into alternative minimum tax calculations.
6. Investment Income and Capital Gains
A taxable brokerage account can continue generating taxable income even when a retiree isn't actively selling investments.
Interest, short-term capital gains and non-qualified dividends are generally taxed as ordinary income, while long-term capital gains and qualified dividends receive preferential tax rates depending on taxable income.
Mutual funds can also sell investments and create capital gains for customers even when the account holder didn’t sell shares, Allec warned.
7. Gambling Winnings
For people who are drawn to the dangerous allure of gambling and get on a lucky streak, be aware this income is also taxable. Allec gave the example of a retired taxpayer who has $15,000 in reported gambling winnings and $15,000 in losses. Breaking even doesn't necessarily mean the tax impact disappears, particularly because gambling losses are subject to separate deduction rules.
Allec's hypothetical retiree could see her calculated income tax liability rise from $890 to $2,620 despite breaking even on the gambling activity. He also warned that gambling income could cause more Social Security benefits to become taxable, even when losses offset some gambling income for other tax purposes.
Don't Forget About State Taxes
Federal tax treatment is only part of the equation. More than 40 states do not tax Social Security income, but states can also have their own rules for retirement account distributions, pensions, municipal bond interest and gambling income.
“This is all to say that just because something was taxed a certain way when you first retired doesn't mean that it will continue to be taxed that way at both the federal and state levels,” Allec said.
This article was provided by MoneyLion.com for informational purposes only and should not be construed as financial, legal or tax advice.
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