Key Takeaways:
- RMDs become mandatory at age 73, and missing one can trigger a penalty of up to 25% of the required amount.
- A new temporary $6,000 deduction ($12,000 for joint filers) is available for taxpayers 65+ through 2028.
- Investment gains, pension income, and annuity payments are all still taxable in retirement and can push you into a higher bracket.
- Where you retire matters — states tax retirement income differently, so location can affect how long your savings last.
The Hidden Tax Traps That Could Cost You in Retirement
Saving for retirement usually takes years of planning. But focusing on savings goals with tunnel vision can lead you to miss some tax rules that can quietly eat into your nest egg if you don’t see them coming. Here’s what to watch for.
Required Minimum Distributions Can Increase Your Tax Bill
If you have money in a traditional IRA or most employer-sponsored retirement plans, you’ll have to start taking required minimum distributions (RMDs) when you hit age 73. That withdrawal counts as taxable income. And if you miss an RMD or take the wrong amount, the penalty can be up to 25% of the amount you should have withdrawn.
The trap here is in the timing. If you wait too long to start taking RMDs, or if you have several accounts and miscalculate the total, you can end up with a bigger tax bill than expected. It helps to plan withdrawals early and strategically so you’re not forced into a higher tax bracket all at once. And if you miss an RMD, try to fix it as soon as possible to reduce the risk of IRS penalties.
Social Security and the Temporary Senior Deduction
Your Social Security benefits can be taxed. Depending on your income, up to 85% of your benefits can be taxable. But the 2025 Trump tax bill created a temporary $6,000 deduction for taxpayers 65 and older ($12,000 for joint filers). This is on top of the usual extra deduction for seniors, and you can claim it whether you itemize or take the standard deduction. This deduction is available through 2028, phases out at higher income levels ($75,000 for single filers and $150,000 for joint filers), and reduces taxable income, which could reduce your overall tax bill.
Investment Gains and Dividends in Retirement
Your investments can still generate taxable income in retirement. Dividends and capital gains from outside your 401(k) or IRA are still taxed each year. Long-term capital gains get a lower rate than ordinary income, which helps. But if you sell a lot of investments in one year, or your dividend income is high, you can accidentally push yourself into a higher tax bracket, or even trigger taxes on your Social Security that you could have avoided with better timing.
Pensions and Annuities
If you have a pension or an annuity, the IRS treats most of that income like a paycheck. Most pension payments are fully taxable if your employer funded the plan with pre-tax dollars. Annuity payments can be more complicated. Think of each annuity payment as having two parts. One part is simply giving you back the money you originally put in, which usually isn’t taxed again. The other part is the investment growth, and that’s generally taxable.
Don’t Forget About State Taxes
Where you live can also affect how much retirement income you keep. Some states don’t tax retirement income at all. Others exempt Social Security benefits but tax pensions or retirement account withdrawals.
Indiana is a good example of how mixed these rules can be. The state doesn’t tax Social Security benefits, but pensions, 401(k) withdrawals, and IRA distributions are taxed as ordinary income. You could also owe county income taxes depending on where you live.
Before relocating in retirement, compare state tax rules along with housing costs and overall cost of living. A state with lower taxes on retirement income could help your savings last longer.
None of the traps above are secret, but they’re easy to miss until you’re already in them. A little planning and a thoughtful withdrawal strategy can help sidestep surprises.
