Retirement Doesn't Always Mean Lower Taxes. It Can Mean Different Taxes. Here's What to Expect.

One of the most common assumptions people approaching retirement make is that their taxes are going to drop. They're no longer getting a paycheck anymore, so how high can the tax bill really be?

Sometimes it's true. Sometimes it's very much not.

What we often see is that retirement doesn't necessarily simplify your tax situation. It changes it. And if you don't understand how it changes, you may end up paying more than you expect.

Your income sources are different — and taxed differently

When you were working, most of your income came from one place: your paycheck. Simple.

In retirement, income may come from several sources at once: Social Security benefits, 401(k) or IRA withdrawals, investment accounts, maybe a pension or annuity. Each of those income sources subject to different tax rules and how they interact with each other can create some outcomes that may catch people off guard.

For example: up to 85% of your Social Security benefit may be subject to federal income tax depending on your total income from other sources. Withdrawals from tax-deferred accounts, such as a 401(k), can increase taxable income and potentially cause a larger portion of Social Security benefits to become taxable.  That may not have happened if you'd structured things differently.

The withdrawal sequencing issue

We sit with a lot of retirees who have money in multiple types of accounts — such as a traditional 401(k), a Roth IRA, a taxable brokerage account. Each of those has different tax treatment when you withdraw.

Traditional 401(k) and IRA withdrawals are generally taxed as ordinary income. Qualified Roth IRA withdrawals are generally tax-free. Investment gains in a taxable account may be subject to capital gains taxes — which are typically taxed at different rates than ordinary income rates.

The order in which you draw from these accounts — and how much you draw from each — can meaningfully affect your tax bill every year. There's no one-size-fits-all answer or single approach that works for everyone. It depends on individual circumstances such as your tax bracket, other income, time horizon, and your long-term goals. But it's worth thinking through deliberately to understand the potential tradeoffs.

Medicare premiums can surprise you

Medicare Part B and Part D premiums are income-based. If your income in retirement exceeds certain thresholds, your premiums can go up — sometimes significantly.

The threshold isn't based on your current income. It's important to note that Medicare looks at income from prior years when determining premiums. So a large 401(k) withdrawal this year could increase your Medicare premiums in two years — even if your income goes back down in between.

Understanding this dynamic — and planning around it — can be an important part of retirement planning.

Roth conversions: a planning consideration

For some investors, the years between retirement and Social Security may present a tax planning window. Your income may be lower than it's been in decades. That's often a good time to consider converting some traditional IRA or 401(k) money to a Roth — paying taxes now at a lower rate to avoid higher taxes later when required minimum distributions kick in.

It's a strategy that requires careful math. But in the right situation, it can be one of the most impactful things you do.

If you haven't thought about this yet

Taxes can meaningfully affect retirement income over time. Thoughtful planning decisions — made early — may provide additional flexibility later.

The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment or tax advice. You should consult with appropriate counsel, financial professionals, and other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.