What the IRS Considers 'Income' in Retirement — and What Doesn't Count

Not all income is treated equally when it’s time to file taxes. Some income sources are fully taxable, while other sources get exemptions or more favorable tax rates.

The way the IRS distinguishes income can affect your Social Security taxes and Medicare premiums. Understanding the tax code and using it when financially planning can save you money. Here’s what you need to know.

Fully taxable income sources

Your salary, tips, bonuses and other wages from full-time, part-time or gig work is treated as ordinary income, which makes them fully taxable. However, there are other income streams that are also fully taxable, including traditional individual retirement account (IRA) and 401(k) withdrawals. That’s especially important to pay attention to when it’s time for required minimum distributions (RMDs), which require you to take out a percentage of your portfolio each year when you reach age 73.

Interest from a bond, bank account or a certificate of deposit (CD) also counts as fully taxable income, though the interest on municipal bonds is typically exempt from federal taxation, and sometimes state and local taxes, too.

Pensions are almost always treated as fully taxable income unless you made after-tax contributions to your plan.

Partially taxable: Social Security

Up to 85% of Social Security benefits can be subject to federal income tax. Your benefits aren’t taxable by the federal government if your income is below $25,000 per year ($32,000 for married couples filing jointly). Up to 50% is taxable if your income is between $25,000 and $34,000 ($32,000 to $44,000 for married couples) with 85% of your benefits taxable if your income exceeds $34,000 ($44,000 for married couples).

Your "combined income" refers to adjusted gross income, tax-exempt interest income and half of your annual Social Security benefits.

Tax-free income sources

Tax-free income sources can work wonders for your retirement strategy and make it easier to navigate rising costs. Roth IRAs and Roth 401(k) plans are tax-free when you withdraw from those accounts since you fund them with after-tax dollars. They do not affect how much of your Social Security benefits are taxed, and they aren’t subject to RMDs.

As previously mentioned, municipal bond interest has some tax exemptions, and you typically don’t have to report life insurance payouts you get as a beneficiary. Health savings account (HSA) withdrawals for qualified medical expenses, gifts received and inherited Roth IRA withdrawals are also typically tax-free.

Review your income

Getting a snapshot of your finances will help you assess your income streams and how much of your Social Security benefits will be taxed. When listing income sources, make sure you distinguish the tax treatment for each option.

There are ways to implement smart tax planning and trim your income, potentially lowering the amount of tax you pay on Social Security benefits. For example, a partial Roth conversion before retiring may help, since you won’t pay taxes when you withdraw from a Roth account.