Taxes in retirement may surprise retirees

Taxes in retirement may surprise retirees

With policy changes creating more opportunities to access retirement savings, more workers are saving for the future. According to the Investment Company Institute, 72% of households own some form of tax-advantaged retirement account such as a 401(k) or IRA. In fact, IRAs alone represent 34% of total retirement assets.

Retirement assets have surged

retirement assets growth

Source: ICI, US Retirement Market, March 2024.

*Data estimated.

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.

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

One of the challenges 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.

Many states tax Social Security, pensions, and distributions from a 401(k) or IRA. There are 13 states that do not tax Social Security. These states may not tax traditional retirement income, but they may have taxes on other types of income such as wages, interest, and dividends.1

Retirement income not taxed (13 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 four states that tax income but do not tax 401(k) or IRA distributions (IL, IA, 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. And it is important to note that federal taxes still apply.

There are other state taxes that could be overlooked, such as property, sales, and estate taxes that may weigh on savings. Individuals may want to consider these factors when choosing a location to retire.

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.

1Source: Kiplinger, “13 states that won’t tax your retirement income,” March 2024.

More in: Retirement/Income, Taxes