Why Taxes In Retirement Get More Complicated

When you're working, taxes usually feel pretty straightforward. You earn a paycheck, and that paycheck gets taxed as ordinary income. That’s it.

Once you retire, things get more complicated.

Your income isn’t coming from one single source anymore. Instead, it’s likely a mix of Social Security, retirement account withdrawals, investment income, equity compensation, and maybe even part-time work or small business income. While all of these help provide the cash flow you need in retirement, each is taxed differently. Some income sources affect the taxation of others in ways that can be subtle and easy to overlook.

For example, taking a distribution from your IRA might increase how much of your Social Security is taxable. It could also push your long-term capital gains into a higher bracket or even cause your Medicare premiums to go up.

When we are looking at taxes in retirement, each source of income falls partially or entirely into one of two broad tax categories:

• Ordinary income includes things like wages, IRA withdrawals, short-term capital gains, and interest. These are taxed at your regular marginal tax rates.
• Preferential income includes things like long-term capital gains and qualified dividends, which are taxed at lower rates — usually 0%, 15%, or 20%, depending on your total income.

Then there are some added costs that aren’t officially called taxes, but they act like them. These include: Medicare IRMAA surcharges, where higher-income retirees pay more for Medicare Part B and Part D. The Net Investment Income Tax (NIIT), a 3.8% surtax on investment income if your modified adjusted gross income is over $200,000 (single) or $250,000 (married filing jointly).

Let’s take a closer look at the three most common sources of retirement income: tax-deferred accounts, Social Security, and taxable brokerage accounts. We will look at how each is taxed and how they can influence one another. Then we’ll explore how a few basic planning steps can make a meaningful difference in your overall tax burden.

1. Traditional IRA and 401(k) Withdrawals

Withdrawals from tax-deferred accounts like IRAs and 401(k)s are usually the simplest to understand from a tax standpoint. These distributions are taxed as ordinary income, just like a paycheck during your working years. Every dollar you withdraw adds a dollar to your adjusted gross income (AGI). 

Sounds simple, right? But here’s where things start to ripple out.

Let’s start with Social Security. Adding IRA income increases your combined income, which can cause more of your Social Security benefits to become taxable. In some cases, one additional dollar from your IRA can pull in 85 cents of Social Security into the taxable column, creating what’s known as the "tax torpedo" effect. 

Then there’s capital gains and dividends. A big withdrawal from your IRA can bump you out of the 0% long-term capital gains bracket. That means you could end up paying 15% or 20% on capital gains that might have been tax-free otherwise.

And don’t forget Medicare premiums. Higher income from your IRA withdrawals can trigger Medicare IRMAA surcharges. That means higher monthly costs for Part B and Part D, and those increases can show up with a two-year delay.

On top of that, there’s the Net Investment Income Tax (NIIT). For high-income retirees, IRA withdrawals can push your modified adjusted gross income (MAGI) above the threshold where an additional 3.8% NIIT applies to your investment income. 

While IRA withdrawals are easy to understand from a tax calculation standpoint, they are rarely isolated. They stack on top of all other income and can unintentionally raise the tax cost of everything else. That’s why strategic withdrawal timing, carefully planning your Roth conversions, and income layering are so important when building a long-term tax strategy in retirement.

2. Social Security Benefits

Most retirees know that Social Security can be taxed. What many don’t realize is just how connected it is to the rest of your income. Depending on your income level, anywhere from 0% to 85% of your benefits could be counted as taxable income. And when they are, that portion is taxed just like ordinary income.

To figure it out, the IRS uses something called combined income. That’s your adjusted gross income, plus any non-taxable interest (like municipal bond income), plus half of your Social Security benefits. Once you have your combined income, your filing status determines how much of your benefits are taxed.

 If you’re single:

Under $25,000 = no Social Security is taxed

$25,000 to $34,000 = up to 50% may be taxed

Over $34,000 = up to 85% may be taxable

If you’re married and filing jointly:

Under $32,000 = no Social Security is taxed

$32,000 to $44,000 = up to 50% may be taxed

Over $44,000 = up to 85% may be taxable

Now, just to be clear, this doesn’t mean you’re paying 85% in taxes. It means up to 85% of your benefits are added to your taxable income and then taxed at your normal rate.

Here’s a quick example.

A couple filing jointly gets $60,000 a year in Social Security and withdraws $50,000 from their IRA. That IRA income already makes some of their Social Security taxable. But if they take just one more dollar from the IRA — so $50,001 — that one dollar can cause an extra 85 cents of Social Security to become taxable. That’s $1.85 in new taxable income from one extra dollar. That’s the tax torpedo in action. 

3. Taxable Brokerage Accounts

Taxable accounts are often one of the most flexible tools in retirement planning. There are no penalties for withdrawals, no required minimum distributions, and no income limits. They also offer the potential for tax efficiency if used strategically.

 Here’s how income from these accounts is typically taxed:

• Short-term capital gains, interest, and non-qualified dividends are taxed as ordinary income.
• Qualified dividends and long-term capital gains are taxed at 0%, 15%, or 20%, depending on your overall income.

This preferential treatment makes these accounts very tax-friendly, especially if your income is low enough to stay in the 0% capital gains bracket. The challenge is that this income stacks on top of everything else. Realizing a large gain from selling an investment can:

• Increase the taxable portion of your Social Security
• Push you into a higher capital gains bracket
• Trigger IRMAA surcharges
• Activate the Net Investment Income Tax

So while these accounts are flexible and powerful, they can also create tax ripple effects if not carefully coordinated with your broader plan.

The Retirement Tax Domino Effect: Meet Susan

 Let’s walk through a real-life example of how these pieces can all connect.

 Susan is 68 and recently retired. She and her husband live on $5,000 a month in Social Security and earn some interest and dividends from their taxable account. At the beginning of the year, only 18.5% of their Social Security was taxable.

Then they made two financial moves.

First, they sold stock for a $50,000 long-term capital gain. Second, on the advice of a financial planner, they converted $150,000 from Susan’s IRA into a Roth.

On paper, both seemed like smart decisions. But here’s what happened:

• 85% of their Social Security became taxable. That added $32,100 in income they weren’t expecting.
• They lost the 0% capital gains rate. That $50,000 gain was now taxed at 15%, costing them $7,500.
• Two years later, they were hit with Medicare IRMAA surcharges — an extra $370 per month in premiums, or $4,440 for the year.
• Their modified adjusted gross income exceeded $250,000, triggering the 3.8% Net Investment Income Tax — another $800.

What they thought would be a $25,000 tax bill on the Roth conversion ended up adding over $12,700 more in hidden costs. The conversion itself wasn’t the problem. The issue was making that move without understanding how it would impact everything else.

Three Big Takeaways

1. Sequence Matters

The order in which you draw from different accounts can dramatically affect your tax bill. Withdrawing from a traditional IRA might make sense one year, while relying on taxable brokerage or Roth accounts could be better in another year. The goal is not just to minimize taxes in a single year, but to smooth your income over time and avoid spikes that push you into higher tax brackets or cause additional surcharges.

 2. Nearly Everything counts toward something else.

An IRA withdrawal does not just create ordinary income. It can cause more of your Social Security to be taxed, reduce your access to the zero percent capital gains rate, or increase your Medicare premiums. Every financial move has the potential to affect multiple parts of your plan.

 3. You need a multi-year plan.

One year of tax savings is helpful. But real value comes from planning across a timeline. A well-structured withdrawal strategy, especially in the years between retirement and required minimum distributions, can reduce your total lifetime tax bill, lower Medicare costs, and give you more flexibility in the years ahead.

Final Thoughts

Retirement taxes aren’t just about percentages. They’re about how different pieces of your income interact with one another. Understanding these interactions helps you avoid unexpected costs and gives you the tools to build a more efficient and confident retirement plan.

If this feels like a lot, we can help. We offer a free Retirement Clarity Meeting, a one-on-one conversation where you’ll walk away with a clearer view of how we help people retire with purpose and peace of mind.

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