How Federal Taxes Work in Retirement (Not What You Expect)

Janet had worked for 35 years, diligently saving in her 401(k). When she retired at 66 with $800,000 saved, she thought she was done paying significant taxes. After all, she'd heard retirement was a lower-tax phase of life.

Then tax season arrived. Her $60,000 in withdrawals plus Social Security benefits pushed her into the 22% federal tax bracket. She owed $11,000 more than she'd budgeted for. "I thought I'd finally get a break from taxes," she told me. "Nobody explained that my 401(k) withdrawals would be taxed just like my old paycheck."

Janet's story isn't unique. Most Americans approaching retirement don't realize that federal taxes in retirement work very differently depending on where your income comes from. And here's the kicker: with proper planning, you can legally minimize what you owe.

The IRS doesn't treat all retirement income equally. Understanding these three categories is your first step toward smarter tax planning.

1. Fully Taxable Income

This income is taxed as ordinary income at your regular federal tax bracket (currently 10%, 12%, 22%, 24%, 32%, 35%, or 37% depending on your total income).

• Traditional 401(k) and 403(b) withdrawals: Every dollar you take out is taxable because you got a tax deduction when you contributed
• Traditional IRA distributions: Same deal, fully taxed as ordinary income
• Pension payments: Most pensions are fully taxable (unless you contributed after-tax dollars)
• Part-time work income: Wages are always taxed as ordinary income

Here's what surprises people: these withdrawals are taxed at the same rates as when you were working. The myth that you'll automatically be in a lower bracket? It only happens if your total retirement income is significantly less than your pre-retirement salary.

2. Partially Taxable Income

Social Security benefits fall into this unique category. Depending on your "combined income" (explained below), you might owe taxes on 0%, 50%, or 85% of your benefits.

This is where it gets tricky. Your combined income is calculated as:

• Adjusted Gross Income (AGI)
• Plus: Tax-exempt interest
• Plus: Half of your Social Security benefits

The taxation thresholds for 2024:

• Single filers: Combined income under $25,000 = 0% taxable; $25,000 to $34,000 = up to 50% taxable; over $34,000 = up to 85% taxable
• Married filing jointly: Combined income under $32,000 = 0% taxable; $32,000 to $44,000 = up to 50% taxable; over $44,000 = up to 85% taxable

Most retirees with any significant retirement savings end up in the 85% taxable range. That doesn't mean you pay 85% in taxes, it means 85% of your Social Security is added to your taxable income.

3. Tax-Free Income

This is the golden ticket of retirement income:

• Roth IRA withdrawals: Completely tax-free after age 59½ (both contributions and earnings)
• Roth 401(k) withdrawals: Also tax-free in retirement
• Health Savings Account (HSA) withdrawals: Tax-free when used for qualified medical expenses (and you'll have plenty of those in retirement)
• Municipal bond interest: Generally exempt from federal taxes
• Life insurance proceeds: Death benefits are typically tax-free

This is why financial planners often push Roth contributions for younger savers. You pay taxes now at potentially lower rates, then enjoy tax-free income later.

Here's some genuinely good news: your standard deduction gets a nice boost once you hit 65.

For 2024, the standard deduction is:

• Single filers under 65: $14,600
• Single filers 65 or older: $16,550 (extra $1,950)
• Married filing jointly (both under 65): $29,200
• Married filing jointly (both 65+): $32,300 (extra $3,100)

What does this mean practically? If you're married and both over 65, your first $32,300 of income is completely tax-free before you owe a penny in federal taxes.

Let's see this in action. Say you're a married couple taking $50,000 from your traditional IRA:

• Gross income: $50,000
• Standard deduction: $32,300
• Taxable income: $17,700
• Tax owed (at 10% bracket): $1,770

That's an effective tax rate of just 3.5% on your $50,000 withdrawal. Not bad at all.

The key insight: your effective tax rate in retirement is often much lower than your marginal rate because of the standard deduction. This is especially true if you're strategic about which accounts you withdraw from first.

If you have money in regular brokerage accounts (not retirement accounts), you'll pay capital gains taxes when you sell investments for a profit. But here's the beautiful part: long-term capital gains (on investments held over a year) are taxed at much lower rates than ordinary income.

The 2024 long-term capital gains rates:

• 0% rate: Taxable income up to $47,025 (single) or $94,050 (married)
• 15% rate: Taxable income up to $518,900 (single) or $583,750 (married)
• 20% rate: Taxable income above those thresholds

Notice that 0% rate? Many retirees with moderate income can actually sell investments and pay zero federal tax on the gains. This is called "tax-gain harvesting" and it's one of the smartest moves you can make in early retirement.

Example: You're married, taking $50,000 from your 401(k). After the standard deduction, your taxable income is $17,700. You could potentially sell investments with gains up to $76,350 ($94,050 - $17,700) and pay 0% federal tax on those gains. It's completely legal and IRS-approved.

Once you turn 73 (as of 2024, thanks to the SECURE 2.0 Act), the IRS forces you to start taking Required Minimum Distributions (RMDs) from traditional 401(k)s and IRAs. The government gave you tax breaks for decades, now they want their cut.

Your RMD is calculated by dividing your account balance by your life expectancy factor (provided by the IRS). At age 73, you'll withdraw roughly 3.8% of your balance. By age 80, it's about 5.3%. By 90, it jumps to 8.8%.

Here's the problem: RMDs can push you into higher tax brackets whether you need the money or not. That $800,000 IRA? At age 73, you'll be forced to withdraw about $30,000. Combined with Social Security, this might bump you from the 12% to the 22% bracket.

The strategy: Consider Roth conversions in your 60s (before RMDs kick in) to reduce future required distributions. You'll pay taxes now on the conversion, but then that money grows tax-free and has no RMDs. It's like pre-paying your tax bill at potentially lower rates.

Important note: Roth IRAs have no RMDs during your lifetime. Another reason they're so valuable in retirement planning.

While this article focuses on federal taxes, don't forget about state taxes. Nine states have no income tax at all: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, Wyoming, and New Hampshire (which only taxes dividends and interest, ending in 2024).

Some states don't tax Social Security benefits. Others offer retirement income exclusions. A few (like California and Connecticut) tax retirement income at the same rates as wages. Where you retire can save you thousands annually.

This is why you see retirees flocking to Florida, Arizona, and Texas. It's not just the weather, it's the tax savings.

Now that you understand how retirement taxes actually work, here's how to use this knowledge:

In your 50s and early 60s (pre-retirement):

• Consider increasing Roth contributions if you're in a lower bracket now
• Explore Roth conversions, especially in years with lower income
• Max out HSA contributions for triple-tax-advantaged savings
• Review your retirement account balance, a massive traditional IRA might mean massive RMDs later

In early retirement (before Social Security and RMDs):

• This is your "low-income window" for tax planning
• Consider larger Roth conversions while you're in lower brackets
• Harvest capital gains at 0% if your income allows
• Delay Social Security to maximize benefits (and minimize taxes later)

After RMDs begin:

• Use Qualified Charitable Distributions (QCDs) to send RMDs directly to charity, up to $105,000 per year, it counts toward your RMD but isn't taxable income
• Balance withdrawals from taxable, tax-deferred, and tax-free accounts to manage your bracket
• Monitor the Social Security taxation thresholds carefully

The key principle: diversify your tax treatment just like you diversify your investments. Having money in traditional accounts, Roth accounts, and regular brokerage accounts gives you flexibility to manage taxes year by year.

Retirement taxes aren't actually that complicated once you understand the rules. Yes, you'll still pay taxes. But with planning, you can control how much and when.

Remember Janet from the beginning? After working with a tax professional, she restructured her withdrawals. She now takes some money from her Roth IRA (tax-free), some from her brokerage account (low capital gains rates), and just enough from her traditional IRA to stay in the 12% bracket. Her tax bill dropped by $4,000 the next year.

The difference between paying too much and paying your fair share often comes down to understanding these rules and planning accordingly. Start learning now, adjust your strategy, and you'll keep more of your hard-earned retirement savings.

Disclaimer: This article provides general information about federal taxes in retirement and should not be considered tax or financial advice. Tax laws are complex and change frequently. Everyone's situation is unique. Before making any financial decisions, please consult with a qualified tax professional, certified financial planner, or financial advisor who can review your specific circumstances.