Dan Reiter, CFP®, CPA, CDFA®,
Retirement income often comes from multiple sources, including Social Security, 401(k)s and IRAs, pensions, and investment accounts. While each source can help fund your retirement, where you take income from can have different tax implications — including potentially affecting how much of your Social Security benefits are taxable.
Understanding how these income sources work together is an important part of planning for retirement and creating a coordinated income strategy.
If you’re wondering how withdrawals from your retirement accounts can impact taxes on your Social Security, you’re in the right place. In this article, we’ll look at how common retirement income sources — including traditional 401(k)s and IRAs, Roth accounts, pensions, and investments — can interact with Social Security taxation and why the source of your retirement income matters.
If you’d like to start with the basics of why Social Security benefits may be taxable and how the taxable portion is calculated, you can learn more in our article, How Is Social Security Taxed in Retirement? What Retirees Should Know.
An additional retirement withdrawal can sometimes affect more than the tax you owe on the withdrawal itself. If the withdrawal increases your provisional income, it may also cause a greater portion of your Social Security benefits to become taxable.
Consider the following example.
A Retirement Example: Sandy JohnsonSandy is 67 years old, single, and retired. She expects to receive the following income sources this year:
Based on the provisional income calculation used to determine taxable Social Security, $7,050 of Sandy’s $18,000 in Social Security benefits is subject to tax. As such, her total adjusted gross income is $35,050. However, as Sandy is over the age of 65, she is eligible for a standard deduction of $17,750 and an additional “senior” deduction of $6,000. After adjusting her gross income for tax deductions that are available, Sandy’s taxable income is $11,300. Sandy’s estimated total tax, therefore, is $1,130. Sandy pays $1,130 in federal income tax, for an average rate on all income received ($46,000) of approximately 2.5%. Now consider what happens when Sandy needs additional money from a retirement account. Let’s assume that Sandy is considering withdrawing an additional $10,000 from her retirement account for a down payment on a new car. At first glance, one might assume that this increases Sandy’s taxable income from $11,300 to $21,300. As Sandy is now mostly within the 12% tax bracket, one would not be faulted for assuming the additional tax on her retirement distribution is about $1,200. However, this would be an incorrect assumption. Why? The additional portfolio distribution also increases Sandy’s Social Security subject to tax! The $10,000 additional retirement plan distribution would push Sandy’s Social Security to its taxable limit of 85%, or $15,300. The result of this is her taxable income is now $29,550 and results in federal taxes of $3,298. The tax difference of $2,168 means that Sandy’s additional distribution is taxed at almost 22%, and her overall tax rate more than doubled from 2.5% to almost 6%. |
Sandy’s example illustrates why simply looking at your tax bracket may not tell the whole story when taking money from a retirement account. A taxable withdrawal can increase your income while also potentially causing a greater portion of your Social Security benefits to become taxable.
Many common retirement income sources may result in an unexpected increase in tax on Social Security. Generally, any income sources that are reported on the tax return and subject to tax are included in the calculation for provisional income.
Additionally, provisional income also includes any tax-exempt interest received, such as interest from municipal bonds.
Because different income sources receive different tax treatment, where your retirement income comes from can matter.
Traditional 401(k) and IRA withdrawals can affect the taxation of your Social Security benefits because these withdrawals generally increase taxable income. This can increase provisional income and potentially cause a greater portion of your Social Security benefits to become taxable.
Distributions from pre-tax retirement accounts such as Traditional IRAs or workplace plans such as 401(k)s are taxed on a dollar-for-dollar basis. As such, every dollar distributed from these plans will be included.
Roth conversions are also included in income and will impact taxation of Social Security. Roth conversions are where you can elect to “convert” all or a portion of your pre-tax retirement account to a Roth.
One important distinction: a traditional 401(k) withdrawal isn't subject to a separate “Social Security tax.” Rather, the taxable withdrawal can increase the income used to determine how much of your Social Security benefit is subject to federal income tax.
Some income sources are not taxable. For instance, qualified distributions from a Roth IRA or Roth workplace retirement plan are not subject to tax. As such, distributions from these accounts are not generally included in the calculation for provisional income.
This creates an important difference between taking money from a traditional IRA and taking the same amount from a Roth IRA. Although either withdrawal can provide money to support your spending needs, they can have different effects on your taxable income and the taxation of your Social Security benefits.
Similar rules apply to personal gifts received from friends and family, as well as alimony or maintenance pursuant to a divorce that occurred after 2018.
One important exception is the interest received from municipal bonds. Although exempted from income tax, these amounts are specifically added back to calculate provisional income.
Receiving pension income will generally be included in the calculation for tax on Social Security, as it is subject to taxation. The only exception to this is for pensions that are not taxable, such as certain pensions resulting from disability.
As a result, taxable pension income can increase provisional income and potentially affect how much of your Social Security benefit is taxable.
Non-retirement accounts get a bit trickier.
Unlike pre-tax retirement accounts where distributions from the account are subject to taxation on a dollar-for-dollar basis, distributions from non-retirement accounts are not subject to tax. Non-retirement accounts are accounts that are not generally created or funded through a workplace plan or have any special tax treatments. These include cash accounts or traditional brokerage accounts.
Income sources in these accounts will most commonly include interest, dividends, and capital gains.
Interest and dividends are included in taxable income in the year they are received, regardless of whether they are distributed from the account.
Let’s say you own a share of Microsoft. If Microsoft pays a dividend, that will be included in your income.
However, let’s say that your Microsoft stock also increases in value by $20 during the year. This appreciation is called an unrealized capital gain.
Unrealized capital gains are not included in income and thus have no impact on provisional income.
If you were to sell your share of Microsoft, however, you have now realized that capital gain and must include it in income.
Key Takeaways
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Where you take money from in retirement can influence your taxable income — and potentially the taxation of your Social Security benefits.
Let’s say you have an IRA, a Roth IRA, and a robust savings account. You need to withdraw funds to support your spending needs.
Where do you get those funds from?
Taking funds from your IRA will generally add taxable income reported on your tax return. On the other hand, qualified Roth withdrawals or using funds from savings generally do not add taxable income.
As such, you may be able to reduce your reported income — and potentially the tax on your Social Security — if you choose to spend more from Roth or cash accounts and delay distributions from traditional IRAs until later.
That does not mean Roth or cash should always be used before an IRA. The appropriate withdrawal strategy depends on your broader financial and tax situation, and decisions made today can have consequences later in retirement.
This is where proactive retirement income planning becomes important. Rather than looking at each withdrawal on its own, proactive planning considers where your retirement income comes from, the potential tax consequences of each withdrawal, and how those decisions work together over time.
There are also retirement tax strategies you may consider before and after Social Security begins as part of a broader retirement income plan, which we will discuss in an upcoming blog article.
Ultimately, your retirement income sources do not exist in isolation. Understanding how withdrawals, Social Security, and taxes interact can help you make more informed decisions about which accounts to draw from and when.
We know there can be a lot to consider when deciding how to create income in retirement. The team at Prosperity Planning is here to help you understand how your income sources work together and build a retirement strategy around your needs and goals. Schedule an introductory meeting to talk through your retirement plans with our team.
Schedule a call with one of our Certified Financial Planner™ (CFP®) professionals today!
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