During your working years, managing taxes may have felt relatively automatic. Your employer calculated payroll withholding, sent part of each paycheck to the government, and deposited the remaining amount into your bank account.
Retirement changes that routine.
Instead of receiving income from one employer, retirees may need to create their own “paycheck” using Social Security, pensions, traditional retirement accounts, Roth accounts, savings, investments, and other assets.
The amount withdrawn may look straightforward, but the tax treatment can vary considerably depending on where the money comes from. In some cases, a withdrawal may also affect other parts of a retiree’s financial picture.
Your Retirement Savings May Not All Be After-Tax Money
It is easy to look at the balance of a traditional IRA or 401(k) and think of the entire amount as available spending money. However, contributions to many traditional retirement accounts were made before income taxes were paid.
The money was generally allowed to grow tax-deferred, meaning taxes were postponed rather than eliminated. When funds are withdrawn, the taxable portion is generally treated as ordinary income.
For example, withdrawing $40,000 from a traditional IRA does not necessarily provide the same after-tax spending power as receiving $40,000 from a checking or savings account.
The withdrawal may feel like you are simply accessing your own savings, but for tax purposes, it may represent income that is being recognized for the first time.
This becomes especially important once required minimum distributions begin, because retirees may eventually be required to withdraw money from certain tax-deferred accounts even when they do not need the full amount for living expenses.
Different Accounts Can Create Different Tax Results
Retirement assets generally fall into three broad tax categories:
- Tax-deferred accounts: Traditional IRAs, 401(k)s, and similar accounts generally create taxable income when money is withdrawn.
- Roth accounts: Qualified Roth withdrawals are generally received free from federal income tax.
- Taxable accounts: Brokerage accounts may create taxable capital gains when investments are sold, but the entire withdrawal is not necessarily taxable.
Cash held in a bank account may be treated differently as well. Withdrawing existing principal from savings does not generally create taxable income, although interest earned on the account may be taxable.
This means two retirees could each withdraw $50,000 for living expenses and experience very different tax consequences depending on which accounts supplied the money.
That difference is one reason some retirees explore whether tax-free income sources may have a role within a broader retirement strategy. The goal is not necessarily to avoid every taxable withdrawal, but to avoid depending on only one type of account for every future income need.
One Withdrawal May Affect More Than the Withdrawal Itself
Traditional retirement account distributions may increase adjusted gross income. That can influence more than the tax charged directly on the withdrawal.
Depending on the retiree’s circumstances, additional taxable income may affect:
- How much of their Social Security benefit is included in taxable income
- The tax rate applied to certain long-term capital gains
- Eligibility for certain deductions or credits
- Medicare Part B and Part D income-related premiums in a future year
- The amount of estimated tax payments or withholding that may be needed
For example, Social Security benefits are not automatically tax-free. The taxable portion depends partly on the retiree’s other income. A larger IRA withdrawal could cause more of those benefits to be included on the tax return.
This is one of the more confusing parts of how Social Security benefits are taxed. The IRA withdrawal does not reduce the retiree’s Social Security benefit, but it may cause a larger portion of that benefit to be treated as taxable income.
This does not necessarily mean the withdrawal was inappropriate. It simply shows why retirement income decisions may need to be viewed together rather than one account at a time.
Withholding May Also Work Differently
Employees are accustomed to receiving a paycheck after federal and state taxes have already been withheld.
Retirement distributions can work differently. Taxes may be withheld from an IRA or retirement-plan distribution, but the amount withheld may not match the retiree’s final tax liability. Some sources of retirement income may have little or no withholding unless the retiree specifically requests it.
As a result, someone could receive the amount they requested throughout the year and still discover that they owe additional taxes when filing their return.
Reviewing withholding and estimated payments with a qualified tax professional may help reduce this type of surprise.
Why Different Income Sources May Provide Flexibility
Fidelity notes that the timing and source of retirement withdrawals can affect taxes in different ways. Drawing from traditional, Roth, and taxable accounts proportionally may, in some situations, help keep taxable income more consistent from year to year.
However, the most appropriate approach depends on the person’s income needs, account balances, required minimum distributions, Social Security benefits, and broader financial circumstances.
Having assets with different tax treatments may provide more flexibility when retirement income is needed. For example, a retiree facing a larger expense may have more options when part of the money can come from a source that does not add to taxable income in the same way as a traditional IRA withdrawal.
This is where a discussion about creating tax diversification in retirement may become relevant. Just as retirees may diversify how their assets are invested, they may also benefit from understanding how different assets could be taxed when income is eventually needed.
Tax diversification does not mean one account type is always better than another. It means recognizing that tax-deferred, taxable, and potentially tax-free sources may each serve a different purpose within a broader retirement plan.
Retirement Income Requires Coordination
The transition from earning a paycheck to creating retirement income involves more than deciding how much money to withdraw.
Retirees may need to consider:
- Which account will provide the money
- How the withdrawal will be taxed
- Whether enough tax is being withheld
- How the income may interact with Social Security
- Whether it could affect future Medicare premiums
- How current withdrawals may influence later required minimum distributions
A retirement income plan should therefore look beyond the balance of each individual account. The larger question is how Social Security, savings, investments, retirement accounts, insurance strategies, and future expenses may work together.
Creations Coastal can help clients understand how their retirement assets and insurance strategies may fit into that broader income picture. Specific tax calculations, withdrawal amounts, Roth conversions, and tax-return decisions should be reviewed with a CPA, enrolled agent, or other qualified tax professional.
Source: Fidelity
