How Taxes Quietly Eat Your Retirement Savings (And What to Do About It)

Most people spend years building their retirement savings and almost no time thinking about what happens to that money when they start spending it. That’s a costly oversight. A couple who saves $1.5 million for retirement and pays no attention to how they withdraw it can easily hand over $300,000 or more to the IRS over the course of a 25-year retirement — not because they did anything wrong, but simply because they didn’t think about sequencing.

Taxes in retirement are different from taxes during your working years. When you’re employed, your employer withholds taxes for you, you have one main income stream, and things stay relatively predictable. Retirement throws multiple income sources at you simultaneously: Social Security, 401(k) withdrawals, Roth accounts, brokerage dividends, maybe rental income. Each one is taxed differently, and the order you pull from them matters more than most people realize.

The Hidden Tax Bracket Problem Nobody Talks About

Here’s something that surprises a lot of people: your Social Security income isn’t fully taxed, but whether it gets taxed at all depends on how much other income you have that year.

The IRS uses something called “combined income” — basically your adjusted gross income plus half of your Social Security benefit — to decide what percentage of your Social Security is taxable. If you’re a single filer and that number stays below $25,000, none of your Social Security is taxed. Push it above $34,000, and up to 85% of your Social Security becomes taxable income.

This creates a sneaky problem. A retiree who takes a large 401(k) withdrawal in a single year might inadvertently push themselves into a situation where their Social Security suddenly becomes mostly taxable. What looked like a $60,000 withdrawal actually created closer to $70,000 in taxable income. The decision to take one big distribution instead of two smaller ones across two years could cost a few thousand dollars for no reason.

The fix isn’t complicated. It’s just about paying attention to your total income each year and planning distributions with that threshold in mind.

Traditional vs. Roth: It’s Not About Which Is “Better”

There’s an ongoing debate in personal finance circles about whether traditional (pre-tax) retirement accounts or Roth (after-tax) accounts are the smarter choice. The honest answer is that both have a place, and the best strategy usually involves having some money in each.

Here’s why. Traditional 401(k) and IRA money has never been taxed. When you withdraw it in retirement, every dollar is ordinary income. If you have $800,000 sitting in a traditional IRA and you start pulling from it, you’re essentially receiving a paycheck that the IRS treats the same way it would treat wages. Depending on your other income, a good chunk of that could be taxed at 22% or higher.

Roth accounts work the opposite way. You paid tax on that money before it went in, and now it comes out completely tax-free. No tax on growth, no tax on qualified withdrawals, and — importantly — Roth IRAs don’t have required minimum distributions during your lifetime.

That last point matters a lot. The IRS requires you to start taking withdrawals from traditional retirement accounts when you turn 73 (as of current rules under the SECURE 2.0 Act). Those are called Required Minimum Distributions, or RMDs. If you have a large traditional IRA and don’t plan around RMDs, you may find yourself forced to take more money out than you actually need — pushing your taxable income up whether you want it to or not.

People who have built up most of their retirement savings in traditional accounts sometimes find themselves in a worse tax situation in their 70s than they expected. Having a Roth account to draw from selectively gives you flexibility to manage your tax bracket year by year.

Roth Conversions: The Move That Feels Counterintuitive

One of the most underused retirement tax strategies is converting money from a traditional IRA to a Roth IRA — deliberately, intentionally, and often in years when your income is lower.

The math goes like this. You pay ordinary income tax on whatever amount you convert in that calendar year. Then the money sits in the Roth account and grows tax-free. Future withdrawals are tax-free. Future RMDs are eliminated.

The best window for doing this is typically the early retirement years, before Social Security kicks in and before RMDs begin. If you retire at 62 and don’t start Social Security until 67, you might have a few years where your taxable income is surprisingly low. That’s often an ideal time to convert a chunk of your traditional IRA at a lower tax rate than you’d otherwise face later.

A simple example: say you retire at 63 with $900,000 in a traditional IRA. Your ordinary income for the year is $30,000. You’re married filing jointly. The 12% federal bracket extends up to about $94,300 in taxable income. You could convert $50,000 to $60,000 of your IRA that year and stay within the 12% bracket. Do that for four or five years and you’ve permanently shifted a significant chunk of your retirement savings out of the tax-deferred bucket and into a tax-free one.

This doesn’t make sense for everyone. If you’re in a high income year, converting would cost more than it saves. The strategy only works when you can convert at a low rate and expect future withdrawals would otherwise hit higher rates. A fee-only financial planner or CPA can help you model this out specifically.

The Asset Location Strategy Most People Skip

This one has nothing to do with how much you save or when you withdraw. It’s about which accounts hold which investments.

If you have a mix of a traditional IRA, a Roth IRA, and a regular taxable brokerage account, you have three buckets with different tax treatments. And the investments sitting in each bucket can be arranged to minimize how much gets taxed each year.

The general principle: put your least tax-efficient investments in your tax-deferred or tax-free accounts, and your most tax-efficient investments in your taxable brokerage.

For example, bonds generate interest income, which is taxed as ordinary income every year. Holding bonds in your traditional IRA makes sense because the tax is deferred. A broad stock index fund, on the other hand, is reasonably tax-efficient — it generates minimal dividends and you can control when you realize capital gains. That’s a better fit for a taxable brokerage account.

REITs (real estate investment trusts) produce a lot of non-qualified dividends, which are taxed as ordinary income. Holding a REIT fund in a Roth IRA means those dividends compound tax-free for decades instead of generating a tax bill every year.

This isn’t about moving money around constantly. It’s a one-time setup decision that can save a meaningful amount over a long retirement without any additional effort after the initial arrangement.

Capital Gains and the Rate Most Retirees Ignore

Here’s something that surprises a lot of retirees: if your income is low enough, your long-term capital gains tax rate is 0%.

Long-term capital gains — profits from selling investments you’ve held more than a year — are taxed at 0%, 15%, or 20% depending on your income. In 2024, the 0% rate applies to single filers with taxable income up to about $47,000 and married couples with income up to about $94,000.

Some retirees, particularly in the early years before Social Security or RMDs kick in, have income low enough to fall into that 0% bracket. If your taxable income is $55,000 as a married couple and $40,000 of that comes from brokerage account capital gains, you’d owe nothing on those gains. Nothing.

This opens up a strategy called “capital gains harvesting” — deliberately selling appreciated investments in a year when you’re in the 0% bracket, capturing the gain tax-free, and either reinvesting or using that money for living expenses. It’s essentially the opposite of tax-loss harvesting, and it’s remarkably underused.

The one thing to watch out for: these capital gains still count toward your combined income for Social Security purposes. So while you might owe 0% in capital gains tax, a large gain could make more of your Social Security taxable. It’s worth doing the full calculation before executing any large sale.

Health Care Costs and HSA Money

If you saved in a Health Savings Account during your working years and didn’t spend it, that money becomes one of the most tax-advantaged assets you own in retirement.

After age 65, you can withdraw from an HSA for any purpose and pay ordinary income tax — which makes it behave exactly like a traditional IRA. But if you use it for qualified medical expenses (which become substantial for most people over 65), withdrawals are completely tax-free. Medicare premiums, dental costs, vision, hearing aids, and many out-of-pocket costs all qualify.

Some people deliberately stockpile their HSA during their working years, paying medical costs out of pocket instead of tapping the HSA, and letting the balance compound. By retirement, they have a dedicated bucket of tax-free money for health expenses that can otherwise be a major financial shock.

If you’re still working and have access to an HSA-eligible health plan, the contribution room is worth using even if you don’t expect to have large medical expenses right now. The triple tax advantage — deductible contributions, tax-free growth, tax-free withdrawals for medical expenses — doesn’t exist anywhere else in the tax code.

State Taxes Are Often Overlooked

Federal taxes get most of the attention, but state taxes on retirement income vary widely and can significantly affect your net income.

Some states don’t tax Social Security income at all. Others exempt pension income. A few states — like Florida, Texas, Nevada, and a handful of others — have no state income tax period. Meanwhile, a state like California taxes virtually all retirement income the same way it taxes wages.

This doesn’t mean you should move purely for tax reasons — cost of living, proximity to family, and healthcare access matter at least as much. But it’s worth factoring into your retirement planning if you’re flexible about location or already considering a move.

Even within states that do tax retirement income, many offer exemptions or deductions for residents over a certain age. These rules change periodically, so it’s worth a quick annual check with a local CPA.

The Real Takeaway

Tax planning in retirement isn’t about finding loopholes or doing anything clever. It’s mostly about recognizing that the IRS taxes different income sources differently, and that the order and timing of your withdrawals has real dollar consequences.

The retirees who pay the least in taxes over a lifetime aren’t necessarily the ones who saved the most. They’re the ones who paid attention to their bracket each year, kept some money in Roth accounts for flexibility, converted when rates were low, and arranged their investments to limit unnecessary taxable income.

Most of this can be set up once and maintained with a light annual review. The bigger risk isn’t complexity — it’s doing nothing and assuming that how you saved automatically determines how you’ll be taxed. It doesn’t. That part is up to you.

This article is for educational purposes only and does not constitute tax or financial advice. Tax laws change frequently. Consult a qualified CPA or fee-only financial planner for guidance specific to your situation.