As you approach retirement, it’s crucial to plan for your financial needs, and one of the most important factors to consider is how different types of retirement income will be taxed. Expenses may fluctuate, and understanding how your income will be taxed can help you manage your budget effectively during retirement.

Here are four common sources of retirement income and how they are taxed:

1. 401(k)s and Traditional IRAs

Both 401(k) plans and traditional IRAs are funded with pre-tax dollars, meaning your contributions reduce your taxable income for the year in which you contribute. While your savings, dividends, and investment growth are tax-deferred within these accounts, the IRS is waiting to collect when you begin withdrawing.

Withdrawals from these accounts are taxed as ordinary income, based on your current tax rate. Additionally, once you reach age 72, the IRS requires you to start taking required minimum distributions (RMDs) from these accounts, and those withdrawals are also subject to taxation.

2. Taxable Investment Accounts

If you have investments such as stocks, bonds, mutual funds, or ETFs outside of tax-advantaged accounts, you will be taxed on any gains when you sell them. The tax rate depends on how long you hold the investment before selling.

If you sell after holding the investment for more than a year, your gains are taxed at long-term capital gains rates, which are typically lower than ordinary income tax rates. The rates for long-term capital gains are 0%, 15%, or 20%, depending on your income, providing significant tax savings compared to the top 37% tax bracket for ordinary income.

3. Pension Income

While most pensions are taxable, certain pensions, such as military or disability pensions, may be partially or entirely tax-free. Your pension provider will send you a 1099 form each year, indicating how much of your pension income is taxable. If you contributed to the pension plan during your working years, you may be able to exclude part of the pension payments from your taxable income.

4. Social Security Benefits

At one time, Social Security benefits were entirely tax-free, but now, depending on your overall income and tax-filing status, Social Security benefits may be subject to tax.

The IRS uses a figure called “combined income” to determine whether your Social Security benefits will be taxed. If your combined income falls below a certain threshold, your benefits may not be taxed.

• If your combined income is less than $25,000 ($32,000 for married couples filing jointly), your benefits are tax-free.

• If your combined income is between $25,000 and $34,000 ($32,000 to $44,000 for joint filers), up to 50% of your benefits may be taxable.

• If your combined income exceeds $34,000 ($44,000 for joint filers), up to 85% of your benefits may be taxable.

Understanding how different sources of retirement income are taxed can help you avoid surprises during your retirement years. Social Security, pension, 401(k), IRA, and taxable accounts all come with different tax implications. For a better understanding of how your specific income will be taxed in retirement, it’s always wise to consult with a tax professional.