Here's how your retirement income is taxed

Social Security

Roughly half of Social Security beneficiaries pay federal income taxes on a portion of their benefits. The tax affects retirees with relatively higher incomes, but the proportion of people who owe taxes is rising.

Taxation of benefits is triggered when certain types of income exceed a threshold. The income formula used to determine this is called “combined income” (also sometimes referred to as “provisional income”). It’s the sum of your adjusted gross income, nontaxable interest and half of your Social Security benefits.

If your combined income is equal to or below $25,000 (for single filers) or $32,000 (for married filers), no tax is owed on your benefits.

Beneficiaries in the next tier of income — between $25,000 and $34,000 for single filers and between $32,000 and $44,000 for married couples filing jointly — pay federal income taxes on up to 50 percent of their benefits. Beneficiaries with income above those levels pay taxes on up to 85 percent of benefits.

Social security

Taxable? Yes.

Social Security benefits are taxed on provisional income, up to 85%. This means you may need to pay income tax on some, but not all, of your Social Security income. Provisional income under $25,000 for individuals and $32,000 for those filing a joint return is not taxable. However, those whose provisional income exceeds these thresholds will have to pay taxes on some of their Social Security benefits. 

The Internal Revenue Service has a calculator available to help you determine how much of your Social Security income is taxable. 

To use it, gather recent pay statements and other proof of income for yourself, and your spouse, if you are filing a joint tax return. The calculator will help you determine your adjusted gross income, and estimate the taxes you may owe. 

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Are other forms of retirement income taxable in California?

Retirement account income, including withdrawals from a 401(k) or IRA, is considered taxable income in California. So is all pension income, whether from a government pension or a private employer pension. All of it is combined with any other income (such as work income) and taxed according to the income tax brackets shown in the table below.

Income Tax Brackets

Single FilersCalifornia Taxable IncomeRate$0 – $9,3251.00%$9,325 – $22,1072.00%$22,107 – $34,8924.00%$34,892 – $48,4356.00%$48,435 – $61,2148.00%$61,214 – $312,6869.30%$312,686 – $375,22110.30%$375,221 – $625,36911.30%$625,369 – $1,000,00012.30%$1,000,000+13.30%

Married, Filing JointlyCalifornia Taxable IncomeRate$0 – $18,6501.00%$18,650 – $44,2142.00%$44,214 – $69,7844.00%$69,784 – $96,8706.00%$96,870 – $122,4288.00%$122,428 – $625,3729.30%$625,372 – $750,44210.30%$750,442 – $1,250,73811.30%$1,250,738 – $2,000,00012.30%$2,000,000+13.30%

Married, Filing SeparatelyCalifornia Taxable IncomeRate$0 – $9,3251.00%$9,325 – $22,1072.00%$22,107 – $34,8924.00%$34,892 – $48,4356.00%$48,435 – $61,2148.00%$61,214 – $312,6869.30%$312,686 – $375,22110.30%$375,221 – $625,36911.30%$625,369 – $1,000,00012.30%$1,000,000+13.30%

Head of HouseholdCalifornia Taxable IncomeRate$0 – $18,6631.00%$18,663 – $44,2172.00%$44,217 – $56,9994.00%$56,999 – $70,5426.00%$70,542 – $83,3248.00%$83,324 – $425,2519.30%$425,251 – $510,30310.30%$510,303 – $850,50311.30%$850,503 – $1,000,00012.30%$1,000,000+13.30%

California offers a senior income tax exemption in addition to its personal exemption. More specifically, seniors receive an extra benefit that allows them to double the standard exemption.

For the 2021 tax year, California increased the personal exemptions for all filing statuses. For singles and married people filing separately, the exemption jumped from $124 to $129, whereas married people filing jointly and surviving spouses saw their exemption increase to $258 from $248. So if you’re over 65 years of age, you can double your exemption to either $258 or $516, depending on your filing status.

Standard Deductions for Retirees

The standard deductions for 2021 are used on tax returns filed in 2022. The standard deduction for 2021 is $12,550 for single taxpayers and married taxpayers filing separately, $25,100 for married taxpayers filing jointly, and $18,800 for heads of household. The standard deduction for married couples filing jointly increased for the 2022 tax year to $25,900, tp $12,950, and to $19,400 for heads of households.

Taxpayers who are 65 years of age or older (whether or not they are retired) are eligible for an extra standard deduction of $1,700 for 2021 ($1,750 in 2022) if they are single or heads of household (and not married or a surviving spouse) and an extra $1,350 for 2021 ($1,400 in 2022) per senior spouse if they are married filing jointly, married filing separately, or a qualified widow(er).

Standard Deductions for Taxpayers Age 65 or Over, Tax Year 2021 Filing Status Standard Deduction Senior Bonus Total Deduction Single $12,550 $1,700* $14,250 Married filing jointly or qualified widow(er) $25,100 $1,350 per senior spouse $26,450 or $27,800 Married filing separately $12,550 $1,350 $13,900 Head of household $18,800 $1,700* $20,500

Standard Deductions for Taxpayers Age 65 or Over, Tax Year 2022 Filing Status Standard Deduction Senior Bonus Total Deduction Single $12,950 $1,750* $14,700 Married filing jointly or qualified widow(er) $25,900 $1,400 per senior spouse $27,300 or $28,700 Married filing separately $12,400 $1,400 $13,800 Head of household $18,650 $1,750* $20,400 Source: Internal Revenue Service

* If not a surviving spouse, otherwise $1,350 in 2021 and $1,400 in 2022.

If your taxable total income falls below these amounts, you won’t owe any taxes. You usually won’t even have to file a tax return (unless you are married filing separately), though you may want to anyway. Filing a return allows you to claim any credits for which you might be eligible, such as the tax credit for the elderly and disabled or the earned income credit. Filing a return also ensures that you receive any refund you may be owed.

Taxpayers who itemize deductions may not claim the standard deduction and bonus amounts. Recent increases in the standard deduction amounts mean the threshold at which older taxpayers benefit more from itemizing than taking the standard deduction is higher. These higher levels may affect your decisions about when to make charitable donations or pay other deductible expenses. You may be able to benefit from itemizing in some years if you can lump large itemizable expenses together so that they fall within a single tax year.

California Retirement Taxes

Photo credit: ©iStock.com/omersukrugoksu
Photo credit: ©iStock.com/omersukrugoksu

In some ways, the Golden State is a perfect place for a happy retirement. It has miles of beautiful coastline and sandy beaches. The weather is sunny and mild. Northern California has the country’s best wine region and mountain ranges such as the Sierra Nevada provide great opportunities for recreation.

As many reasons as there are in favor of a California retirement however, there may be just as many against it. For starters, it has a cost of living that is far higher than the national average.

And then there are the taxes. While California exempts Social Security retirement benefits from taxation, all other forms of retirement income are subject to the state’s income tax rates, which range from 1% to 13.3%. Additionally, California has some of the highest sales taxes in the U.S.

A financial advisor in California can help you plan for retirement and other financial goals. Financial advisors can also help with investing and financial plans, including taxes, homeownership, insurance and estate planning, to make sure you are preparing for the future.

Withdrawals from a pension or retirement account

It may seem unfair that your IRA or 401(k) withdrawals are subject to taxes in retirement, but remember that since you never paid taxes on that money in the first place, it kind of makes sense that you’d be taxed down the line. The same rule applies for pension plans — your withdrawals will be taxable in retirement.

Now, if you have a Roth IRA, there’s some good news: Because Roth accounts are funded with after-tax dollars, you won’t pay taxes on withdrawals in retirement. As long as your Roth was opened at least five years before you start taking distributions, you won’t pay a dime in taxes on those withdrawals.

Finally, if you have an annuity that you funded with after-tax dollars, you might pay taxes on part of your withdrawals in retirement. Annuity tax rules are a bit complicated, but in a nutshell, when you take money out of an annuity, the portion that represents your principal investment is not subject to taxes. You will, however, pay taxes on the portion that’s considered investment gains.

When you’re living on a fixed income, unexpected taxes can really throw you for a loop. So, as you sit down to create a retirement budget, be sure to take taxes into account. If you go into retirement knowing full well that your income will be taxed, it’ll soften the blow and help you avoid unpleasant financial surprises. 

Tax-Free Retirement Income

The following sources of retirement income are generally tax-free:

  • Roth IRA withdrawals: Roth IRA withdrawals are tax-freeif you meet the Roth IRA withdrawal requirements. Roth IRA withdrawals are not included in the formula that determines how much of your Social Security is taxable. They also are not included in the formula that determines how much in Medicare Part B premiums you will pay.
  • Interest income from municipal bonds: Most municipal bond income is free from federal income taxes. You may be subject to state income taxes on this form of retirement income.
  • Income from a reverse mortgage: Monthly payments or lump sums received from a reverse mortgage are not taxable, giving a reverse mortgage a hidden advantage that many people overlook.
  • Any return of principal or cost basis: Once all gain has been withdrawn from an annuity, you would be withdrawing your cost basis or principal. Withdrawals of basis are not counted as taxable retirement income.
  • Gain from the sale of your home: Most people receive gains from the sale of their primary residence tax-free if the gain is less than $250,000 for a single person or less than $500,000 for married filers, and if the seller has lived in the home for at least two of last five years and meets other IRS requirements.

Tax Withholding and Estimated Tax Payments

The taxable part of your pension or annuity payments is generally subject to federal income tax withholding.

You may be able to choose not to have income tax withheld from your pension or annuity payments (unless they’re eligible rollover distributions) or may want to specify how much tax is withheld. If so, provide the payer Form W-4P, Withholding Certificate for Pension or Annuity Payments or a similar form provided by the payer along with your social security number (SSN). If you’re a U.S. citizen or resident alien, you must provide the payer with a home address in the United States (or its possessions) to be able to choose to have no tax withheld. Payers generally figure the withholding from periodic payments of a pension or annuity the same way as for wages. If you don’t submit the Form W-4P withholding certificate, you don’t provide your SSN, or the IRS notifies the payer that you gave an incorrect SSN, then the payer must withhold tax as if your filing status is single with no adjustments in Steps 2 through 4.

If you pay your taxes through withholding and the withheld tax isn’t enough, you may also need to make estimated tax payments to ensure you don’t underpay taxes during the tax year. For more information on increasing withholding tax, making estimated tax payments, and the consequences of not withholding the proper amount of tax, refer to Publication 505, Tax Withholding and Estimated Tax.

Additional 10% Tax on Early Distributions

If you receive pension or annuity payments before age 59½, you may be subject to an additional 10% tax on early distributions, unless the distribution qualifies for an exception. The additional tax generally doesn’t apply to any part of a distribution that’s tax-free or to any of the following types of distributions:

  • Distributions made as a part of a series of substantially equal periodic payments that begins after your separation from service.
  • Distributions made because you’re totally and permanently disabled.
  • Distributions made on or after the death of the plan participant or contract holder.
  • Distributions made after your separation from service and in or after the year you reached age 55.
  • Distributions up to $5,000 made within a year of the birth or adoption of your child to cover birth or adoption expenses.

For other exceptions to the additional 10% tax, refer to Publication 575, Pension and Annuity Income and Instructions for Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. For relief for taxpayers affected by COVID-19 who take distributions or loans from retirement plans, refer to Notice 2020-50PDF and IR-2020-124.

Medicare surcharges

Higher-income retirees pay surcharges on their premiums for Medicare Part B (outpatient services) and Part D (prescription drugs). Formally known as Income Related Monthly Adjustment Amounts, they can increase Medicare costs substantially.

The Social Security Administration determines whether you must pay a surcharge using the most recent tax return it can access from the I.R.S. — generally two years before the year for which the premium is being determined. This look-back feature means that the surcharge can be triggered for middle-class workers in the early years of retirement, because it factors in your final years of wage income.

There are five surcharge brackets, defined by your modified adjusted gross income. Medicare enrollees falling into these brackets shoulder a higher share of total program costs. While Medicare sets the standard Part B premium each year to cover 25 percent of total program costs, those subject to surcharge pay 35 percent to 85 percent of those costs.

This year, that translates to a Part B surcharge of $68 a month for a retiree filing a single tax return with modified adjusted gross income between $91,000 and $114,000. Her total premium is $238.10, instead of $170.10. The Part D surcharge is smaller — $12.40 this year for seniors falling into the first bracket.

From there, the surcharge levels jump substantially. And, there’s nothing graduated about them, Mr. Slott notes. “I call it a cliff — if you’re one dollar over, you’re paying the full amount.”

Roth IRAs

Taxable? No, with exceptions.

Withdrawals made from a Roth IRA are generally tax-free, but there are exceptions. Account holders can only make tax-free withdrawals after holding a Roth IRA for at least 5 years. In addition, withdrawals made before age 59.5 are subject to a 10% early withdrawal penalty. However, there are some exceptions that may allow account holders to avoid the penalty, such as using the money to fund a first-time home purchase, college expenses or childbirth costs.  

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IRAs

(Photo: Getty Creative)

The appeal of individual retirement accounts (IRAs) is that it can be a supplemental savings vehicle to a 401(k) or 403(b) because $6,000 ($7,000 for those age 50 and up) pre- or post-tax dollars can be contributed this year. There are key differences between the two types of IRAs and how they're taxed.

Traditional IRAs

With a traditional IRA, Ciprich pointed out “you get a deduction on the money that you put into them” because those contributions are made with pre-tax dollars. The earnings in the traditional IRA are tax deferred until you’re required to start taking distributions at age 72.

Those withdrawals are taxed as regular income the rate is based on your income the year you made the withdrawal. If you take out money before age 59½, that is considered an early withdrawal and comes with a 10% penalty and in most cases, any associated income taxes.

Roth IRAs

Roth IRAs grow with post-tax dollars, but “there is no income tax paid on either the gain or the distribution,” Ciprich explained, provided you meet certain requirements. Contributions you made can be withdrawn tax-free at any time. Earnings can be taken out tax-free as long as you’re 59½ or older and you had the Roth IRA for at least five years.

Unlike a traditional IRA, contributions you make into a Roth are not tax deductible.

Ranking method

The "tax-friendliness" of a state depends on the sum of income, sales and property taxes paid by two hypothetical retired couples.

To determine income taxes due, we prepared tax returns for each state and the District of Columbia for both couples. The first couple had $15,000 of earned income (wages), $20,500 of Social Security benefits, $4,500 of 401(k) plan distributions, $4,000 of traditional IRA withdrawals, $3,000 of Roth IRA withdrawals, $200 of taxable interest, $1,000 of dividend income, and $1,800 of long-term capital gains for a total income of $50,000 for the year. They also had $10,000 of medical expenses, paid $2,500 in real estate taxes, paid $1,200 in mortgage interest, and donated $1,900 (cash and property) to charity.

The second couple had $37,500 of Social Security benefits, $26,100 of 401(k) plan distributions, $18,200 of private pension money, $6,000 of traditional IRA withdrawals, $2,000 of Roth IRA withdrawals, $2,000 of taxable interest, $4,000 of dividend income, and $4,200 of long-term capital gains for a total income of $100,000 for the year. They also had $10,000 of medical expenses, paid $3,200 in real estate taxes, paid $1,500 in mortgage interest, and donated $4,300 (cash and property) to charity.

We calculated these 2020 returns using software from Credit Karma (some adjustments were made to account for certain 2021 tax law changes).

How much they paid in sales taxes was calculated using the sales tax deduction tables in the instructions for federal Schedule A (Form 1040) and the Tax Foundation's 2021 midyear average combined sales tax rates.

How much each hypothetical couple paid (and deducted on their income tax return, if allowed) in property taxes was calculated by assuming a residence with a $250,000 assessed value for the first couple and a $350,000 assessed value for the second couple. We then applied each state's median property tax rate to that appropriate amount.

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