Is Retirement Income Considered Earned Income?

Is Retirement Income Considered Earned Income? What to Know About Paying Taxes During Retirement

Retirement is an exciting prospect for any working professional moving on to the next chapter in life. However, while retirement is an excellent time to do what you love and surround yourself with family, many adults preparing for retirement neglect to consider how retirement income is taxed.

Knowing what your retirement plan income includes and your tax obligation starts by understanding whether your retirement income is earned income. By preparing for your financial future, you can navigate retirement seamlessly and avoid facing any unexpected costs.

This article will help you prepare for your financial future by diving deep into whether retirement income is considered earned income, how retirement income is taxed, and what you should know to create a sustainable and practical retirement plan. Let’s get started!

What is Earned Income?

Earned income is the income you receive from actively working. The primary types ofearned incomeinclude the following:

• Salary, wages, or tips where federal income taxes are withheld
• Income from a position where your employer doesn’t withhold taxes
• Income made from self-employment
• Union strike benefits
• Some disability benefits, if received before the minimum retirement age
• Nontaxable Combat Pay

Earned income does not include the following:

• Income received for work completed during incarceration
• Interests and dividends
• Pensions or annuities
• Unemployment benefits
• Alimony
• Social Security
• Child support

Is Retirement Income Considered Earned Income?

That said, it’s time to ask the big question: is retirement income considered earned income?

Whether your retirement income is taxable depends on a few factors, including the source of your retirement funds. For example, suppose you are funding your retirement from stocks, bonds, or additional financial assets. In that case, this is not considered earned income. Additionally, pension payments, Social Security benefits, and annuities are not considered earned income in retirement.

However, the money you receive during retirement is often subject to taxes. For example, pensions, annuities, and Social Security benefits are taxable, and the amount you’ll pay each depends on your retirement income.

Additionally, if you plan to withdraw funds from yourIRAs and 401(k)accounts, your withdrawals may be subject to taxation. Given the numerous income sources that influence how much tax you’ll pay during retirement, having enough money saved to cover these additional costs is crucial.

What Determines My Tax Liability During Retirement?

While preparing to pay more taxes in retirement isn’t exciting for most, there are ways to prepare yourself for the task. For instance, consider the factors that determine your tax liability upon retirement to understand what you’ll be facing:

• Your filing status
• All of your retirement income sources
• Your total annual income

Though it might seem stressful, there are ways to prepare for paying your tax bill to ensure you don’t run out of money during retirement. This process starts by understanding how your social security is taxed upon retirement.

How are Social Security and Medicare Taxed During Retirement?

You will typically pay Social Security and Medicare taxes on your wages earned during retirement. Depending on your earnings, you may reach a higher tax bracket and threshold for your current Medicare premiums.

An essential factor to consider when planning for your retirement is that if your only source of income during retirement is your Social Security benefits, you likely won’t have to pay taxes. This is because taxes primarily depend on your retirement plan income. Income from a Social Security plan is not large enough to incur taxes; however, if you use Social Security benefits alongside other income sources, your Social Security benefits could create a tax bill, even if your other sources are considered tax-exempt.

The amount you’ll pay on taxable Social Security benefits relies on a few factors, most notably your combined income or the total sum of costs for the following:

• Tax-exempt interest income, including any interest you receive on bonds
• 50% of your total Social Security benefits for the financial year
• Your total income is made up of all sources, including but not limited to salaries, gratuities, interest, wages, profits from investments, regular payments from retirement accounts, and pensions. Adjusted gross income describes your total income minus necessary deductions and exclusions. These adjustments include deductions for your IRA contributions, health savings account contributions, student loan deductions, or contributions to a self-employedretirement plan. Note that your unearned income counts toward your adjusted gross income for state and federal tax returns.

These factors will determine how your Social Security benefits are taxed and the portion of these benefits eligible for taxation.

Percentage of Social Security Benefits Subject to Tax Depending on Your Combined Income

Depending on your combined income and tax bracket amount, you will pay Social Security taxes at a different percentage for taxable benefits. Below is abreakdownof what you can expect depending on where you fall in terms of combined income:

How are Traditional IRAs and 401(k)s Taxed During Retirement?

While traditional IRAs and 401(k) retirement accounts are tax-deferred, upon retirement, account holders will begin paying taxes when withdrawing funds during retirement. The savings, investment funds, and dividends collected in your account grow as you continue saving; however, taxes will apply to your funds when you withdraw.

Additionally, these plans have required minimum distributions, meaning that, at some point, you must make a withdrawal. These withdrawals are taxable following ordinary income tax rates but exclude after-tax and nondeductible contributions to the account.

How are Roth IRAs and 401(k)s Taxed?

Unlike the traditional versions, Roth IRAs and 401(k)s include tax-free withdrawals during retirement. Contributions to these accounts are nondeductible, but if you want to avoid hefty taxes during retirement, these plans could suit you. Keep in mind the following factors:

• You must have your Roth IRA or 401(k) account for at least five years before taking tax-free withdrawals.
• Generally, you must be age 59 ½ before you can withdraw tax-free funds. Withdrawing funds before this age is tax-free but incurs a hefty 10% early-withdrawal penalty.
• With Roth IRAs, the five-year mark begins at your first deposit. With Roth 401(k)s, the five-year mark begins January 1st, the year following your first contribution.

How are Pensions Taxed During Retirement?

Your pension payments are fully taxable at the same rate that you pay income tax ordinarily. However, it is essential to note that some states do not consider your pension payments taxable income for specific state income taxes.

How Are Annuities Taxed During Retirement?

Your principal payment is tax-free if you purchase an annuity plan for retirement income. The remaining funds in your annuity account are taxed at the ordinary income rate. However, different terms apply depending on whether you purchased the annuity with pretax funds; in this situation, your annuity payments are taxed as ordinary income.

How are Stocks, Bonds, and Mutual Funds Taxed During Retirement?

The final factor to consider when determining the amount you’ll pay in taxes during retirement is whether you sell stocks, bonds, and mutual funds to support your retirement. These investments are taxed at long-term capital gains rates, meaning that you can expect rates of 0%, 15%, or 20%.

These rates are based on specific income thresholds and adjusted based oninflationduring particular tax years. For example, in 2023, single filers with an income below $44,625 are eligible for the zero percent long-term capital gains rate. Income between $44,625-$492,300 is subject to the 15% capital gains rate, while individuals exceeding this amount fall into the 20% long-term capital gains rate.

Is Retirement Income Taxable in Every State?

Not all states tax your retirement income; some states do not have income tax at all. These states include the following:

• Florida
• Alaska
• Nevada
• Tennessee
• South Dakota
• Texas
• Wyoming
• Washington
• New Hampshire (note that while New Hampshire doesn’t have an income tax, the state has taxes on interest and dividend payments)

Additionally, the following states do not tax your retirement income:

• Illinois
• Mississippi
• Iowa
• Pennsylvania