How Different Types of Retirement Savings Are Taxed

Matt Boyd is a senior director of high-net-worth tax planning at Northwestern Mutual.

The U.S. tax code can be complicated—and may seem even more so when you retire. That’s because in retirement, you have to create your own paycheck. You may lean on Social Security, a 401(k), Roth accounts and other sources to get the money you’ll need. But it’s important to know that these income sources may be taxed differently.

For many people, this concept can feel overwhelming and complicated. But it also presents an opportunity: If you know what you’re doing, you can use different retirement income sources to your advantage—allowing you to strategically manage your taxes, which can help you keep more of your money.

Here are some common retirement income sources and how they’re taxed.

How different retirement income sources are taxed

Social Security

Because Social Security provides guaranteed income for as long as you live, it’s typically a central part of a retirement income plan. Though Social Security is taxable, you don’t pay tax on your full benefit. The percentage of your Social Security benefit that is taxable depends on your “modified adjusted gross income” in the applicable year. This can be difficult to calculate, especially when the benefit is partially taxable, but you will never be taxed on more than 85 percent of your benefit, and in some cases, the benefit may be tax exempt.

Qualified investments

Qualified investments refer to investment accounts that qualify for certain special tax benefits, such as your 401(k), 403(b) or IRA. This is money that probably hasn’t ever been taxed. Typically, you receive a deduction when money is contributed to these accounts, and the growth is tax deferred. The government wants its cut eventually, and will collect tax on this money when it is withdrawn—typically after you retire. You will pay ordinary income tax on these distribution

And because the government wants to ensure it collects tax on these accounts sooner than later, it requires you to withdraw a minimum amount from your qualified accounts even if you don’t need the income. Beginning in the year you turn 73 (or 75, if you were born in 1960 or later), you are required to start making those withdrawals, known as required minimum distributions (RMDs). If you don’t withdraw the full RMD by the end of each calendar year (or by the tax deadline for your first RMD year), you’ll face a stiff penalty. So it’s a good idea to calculate how much you’ll need to withdraw each year and make sure you’re not pushing yourself into a higher tax bracket unnecessarily.

Roth accounts

Your Roth 401(k) or Roth IRA includes money that has already been taxed. So—bonus—you won’t typically owe any tax when you withdraw from Roth accounts. The years immediately following retirement can be an ideal time for converting traditional qualified accounts to Roth. These years, before social security and RMDs, tend to be relatively low-income years, so you may have the opportunity to convert to a Roth at a lower tax rate than you would anticipate withdrawing via RMDs in subsequent years.

Nonqualified investments

These are investments that don’t qualify for special tax treatment (hence, the moniker “nonqualified”). Taxes vary by the types of investments. Here, we’ll cover stocks and bonds.

When you sell a stock, the amount you paid for the stock (known as the basis) is tax-free. But the growth on the stock will be taxed at sale. This is called capital gains tax. If you own the stock for a year or less, a sale at a gain is considered a “short-term capital gain,” subject to ordinary income tax. If you own the stock for longer than a year, a sale at a gain is considered a “long-term capital gain” subject to preferential tax rates, ranging from 0% to 20% (versus 10% to 37% on ordinary income).

If you sell an investment for less than what you paid for it, you can use the loss to offset or reduce other taxes you may owe. This is known as tax-loss harvesting. Just keep in mind that there are limitations on how much capital loss can offset other retirement income sources. Many stocks also pay dividends, which often have preferential tax rates, the same as long-term capital gains.

When buying and selling bonds on the secondary market, the same rules apply for calculating gains and losses, although bonds tend to generate lesser gains or losses, compared to stocks. If you receive interest payments on a bond, the tax you owe depends on the type of bond. Generally, you will owe ordinary income tax on bond interest from corporate bonds, but interest from municipal bonds is free from federal taxes, and sometimes free from state taxes. Some bonds issued by the federal government, such as I bonds or Treasury Inflation-Protected Securities (TIPS), are taxed as ordinary income for federal tax, but exempt from state tax. A financial or tax professional can help you understand more about how particular types of bonds may be right for your situation.

In many cases, you won’t own stocks and bonds directly because you will buy them through a fund, like an ETF or mutual fund. In that case, your taxes are based on the underlying investments in the fund. However, the people who operate the fund will make decisions about when to buy and sell investments the fund holds, which can result in you owing taxes. So it’s a good idea to get a sense of how a particular fund operates.

Pensions

While pensions are less common than they once were, some people are fortunate to still have one. For the most part, pensions are taxed like a traditional 401(k), meaning the participant was not taxed as the pension was funded, but will be taxed as the pension is distributed. You’re likely to owe ordinary income tax on a pension distribution but check on your specific circumstances, as there are some exceptions.

Income annuities

You can make both qualified and non-qualified contributions to an income annuity. As you receive your annuity payouts over time, you will owe ordinary income tax on your qualified contributions and any earnings within the annuity.

However, you won’t owe taxes on any non-qualified contributions. In that case, the insurance company will pay out what’s called “a return of premium over time.” Typically, a portion of your payment will include that return of premium, while the rest of the payment (the accumulated earnings in the annuity) will be taxable.

Whole life insurance

If you bought whole life insurance when you were younger, then you’ve likely accumulated a sizable amount of cash value. This is money that won’t decline with the market—which makes whole life insurance an effective hedge against market downturns in retirement. Similar to other assets, you pay no taxes on your basis. Any gain is taxed at your ordinary income tax rate if you surrender your policy. However, if you borrow against your policy rather than withdraw the cash value through a surrender, you won’t owe tax on that amount as long as your policy stays in place.

State taxes

The particular state where you live during retirement can also have a significant impact on tax on retirement income. Many states exempt social security from tax. Some states exempt retirement account distributions, like IRAs and 401(k)s. And some states have no income tax at all.

Managing your taxes in retirement

By accumulating retirement income in different “buckets,” like those described above, you’ll create more flexibility in retirement to handle a range of scenarios, including managing taxes. For example, if you have a significant expenditure in one year, the ability to access a Roth account, or to borrow against your life insurance policy, will enable you to meet that expenditure while avoiding maximum tax rates. Your Northwestern Mutual financial advisor, together with your tax professional, can guide you through the retirement years, minimizing your tax liabilities, and thereby maximizing your retirement savings.

This publication is not intended as legal or tax advice. Financial representatives do not provide tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor.

The primary purpose of permanent life insurance is to provide a death benefit. Using permanent life insurance accumulated value through policy loans to supplement retirement income will reduce the death benefit and may affect other aspects of the policy.