Retirement is a new phase of life, and so is your tax situation. Knowing what counts as income and how it’s taxed can make a big difference in how long your money lasts. Below are some of the most common tax questions retirees ask.

Can I Avoid the Income Tax in Retirement? What Would That Take?

It’s tough to avoid income tax entirely, but some retirees can reduce their tax bill significantly. If most of your income comes from Roth IRA withdrawals, municipal bond interest, or a Health Savings Account (HSA) used according to its rules and limitations, you may pay very little in taxes. However, this typically takes careful planning in the years leading up to retirement. Many people find it more realistic to focus on minimizing taxes, not eliminating them. Tax diversification, which is having a mix of taxable, tax-deferred, and tax-free accounts, can give you more flexibility.

What Actually Counts as “Income”?

In retirement, “income” can include things like pension checks, Social Security, IRA or 401(k) withdrawals, annuity payments, and wages if you’re still working. It also includes capital gains from selling investments, interest from savings, and dividends. Even some forms of insurance or legal settlements may count. If it’s money coming in, there’s a good chance the IRS has rules for how it’s taxed.

Do Dividends Count as Income?

Yes. Dividends count as income, but not all dividends are taxed the same. “Qualified” dividends are taxed at long-term capital gains rates (which are generally lower), while “ordinary” dividends are taxed as regular income. This distinction, which is often based on how long you’ve held the underlying asset, can impact your overall tax burden and investment strategy.

What’s the Difference Between Capital Gains and Income Tax?

Income tax applies to wages, withdrawals from tax-deferred accounts, and most forms of retirement income. Capital gains tax, however, is applied when you sell an investment for more than you paid for it. Long-term capital gains (for assets held over a year) are taxed at lower rates than short-term gains. Moving money in a brokerage account can trigger capital gains taxes, even if you’re just rebalancing your portfolio. That’s why timing and strategy matter when selling assets.

What’s the Tax Difference Between Moving Money Within or Out of a Retirement Account?

If you sell assets within a retirement account like an IRA or 401(k), you won’t pay capital gains taxes at the time of sale. However, when you withdraw from a traditional account, the entire withdrawal is taxed as ordinary income. In contrast, selling assets in a brokerage account (non-retirement) triggers capital gains taxes, and those gains are taxed based on how long you held the asset. Understanding these differences can help you choose the most efficient way to generate income.

Are There Any Purely Tax-Free Income Sources?

Yes. Municipal bond interest is often tax-free at the federal (and sometimes state) level. Roth IRA withdrawals (if qualified) are also tax-free. However, these options may come with trade-offs: for example, municipal bonds tend to offer lower returns than taxable investments, and Roth IRA contributions are taxable. Sometimes, choosing a higher-earning taxable investment is actually more beneficial, even after paying tax, depending on your goals.

Are Social Security Benefits Taxable?

They can be. If your combined income, including half of your Social Security benefits plus other income, exceeds certain thresholds, up to 85% of your benefits may be taxable. Planning withdrawals and coordinating income sources can help reduce this.

Are Roth IRA Withdrawals Taxable?

No, not if they’re qualified—meaning the account’s been open at least five years and you’re over age 59½. These withdrawals are completely tax-free, making Roth accounts a powerful retirement tool.

Are Required Minimum Distributions (RMDs) Taxable?

Yes. Traditional IRA and 401(k) RMDs are taxed as ordinary income. The IRS requires these distributions starting at age 73 (for most retirees). Not taking them can result in stiff penalties, but there are ways to offset the tax hit, like using Qualified Charitable Distributions.

Want to see how smart tax planning could impact your retirement income? A financial advisor can help you build a personalized strategy to keep more of your money working for you. Reach out to us today to get started.