The tax bite on retirement income may surprise retirees

Bill Cass, CFP®, CPWA®

Bill Cass, CFP®, CPWA®, 04/14/21


With access to retirement savings plans, savers focused on preparing for retirement have been able to build assets for the future.

Challenges can emerge for investors who have not planned for the impact of taxes when it’s time to make withdrawals. This requires careful planning around taxes in retirement, including local taxes depending on where you live.

Retirement assets have surged

Since the emergence of 401(k) plans in the early 1980s, there has been tremendous growth in retirement savings accounts. Assets in IRAs and defined contribution plans have grown to nearly $22 trillion in 2020 from $5.6 trillion in 2000.

retirement assets chart

The good news is that, overall, many investors have leveraged these savings accounts to prepare for retirement.

One of the challenges facing investors is that most of these savings are held in pre-tax accounts, and the assets will be taxed when distributed in retirement. Tax-free Roth IRA accounts, for example, comprise only 10% of total IRA assets.

Investors may overlook the impact of local taxes

While many retirees are focused on the impact of retirement account distributions on their federal 1040 tax form, some may not be aware of how their particular state treats these distributions from a tax perspective.

Here’s a look at how states currently tax retirement income (Tax Foundation, CCH Wolters Kluwer):

Retirement income not taxed (12 states total)

  • This includes seven states that do not currently tax income (AK, FL, NV, SD, TX, WA, WY), two states that only tax dividend and interest income (NH, TN), and three states that tax income but do not tax 401(k) or IRA distributions (IL, MS, PA)
  • Alabama and Hawaii do not tax retirement pension income, but do include IRA or 401(k) distributions as income for state taxes

Remaining states vary widely in taxation

  • Other states may limit the amount of tax by income level and/or type of retirement income
  • For example, while California fully taxes retirement account distributions,* Colorado allows retirees to exempt $20,000 of income for those age 55 to 64, and $24,000 if age 65 and older

*California does allow a subtraction from income for railroad retirement pension income.

How state taxation may impact a retirement nest egg over time

Consider a comparison of three states, California, Colorado, and Florida. The example assumes:
  • $1,000,000 IRA
  • RMDs over first 10 years in retirement based on IRS uniform table scheduled to take effect in 2022
  • Marginal state income tax rates for CA (8%), CO (4.63%), and FL (0%)
  • 5% annual growth rate on IRA balance
  • Total RMDs over first 10 years = $472,284
The results vary widely among the states:

example of taxes paid in three states

Certain states may tax Social Security retirement benefits

Many retirees receiving Social Security realize that they need to report at least a portion of those benefits as income on their federal tax return.
  • Between $25,000 and $34,000 ($32,000 and $44,000 for couples): Up to 50% of benefits reported as taxable income
  • Over $34,000 ($44,000 for couples): Up to 85% of benefits reported as taxable income

†Source: IRS Notice703. Income calculation or taxation of Social Security benefits equals your adjusted gross income (AGI), one half of Social Security benefits, and tax-exempt municipal bond interest. Income from Roth accounts does not negatively impact taxation of Social Security benefits.

However, many retirees may not realize that certain states tax Social Security as well.
  • Currently 37 states do not tax Social Security, while 13 states will tax Social Security in some form
  • States that may tax Social Security benefits in some form will vary in method. A number of states (CO, CT, KS, MN, MO, ND, NE, RI, VT, WV) provide exemptions from income based on certain factors (age, income), while others (MT, NM) have modified tax systems; Utah follows the federal system for taxation of benefits

Review tax status of retirement income

It’s important for investors to understand the tax treatment of retirement savings. In reviewing retirement plans with a financial professional, savers may want to consider a tax diversification strategy, where assets are allocated to differing buckets according to tax status. This strategy may help retirees plan withdrawals based on their individual tax situations in retirement.

Additional resources

“State Taxation of Retirement, Pension and Social Security Income,” the Tax Foundation, AARP, and “State by State Guide to Taxes on Retirees.”

325833