Tax Brackets in Retirement: Why Earning Less Can Sometimes Mean Paying More

Many people assume that taxes automatically go down in retirement. After all, earned income often decreases once paychecks stop. However, retirement taxes are not always that simple. In fact, some retirees find themselves paying more in taxes, even while earning less, because of how tax brackets interact with phaseouts, credits, and income cliffs.

One reason this happens is that retirement income often comes from multiple sources that are taxed differently. Social Security benefits, pensions, required minimum distributions (RMDs), investment income, and even tax-exempt interest can all affect your taxable income in unexpected ways. When these income streams overlap, they can trigger thresholds that cause taxes to rise more quickly than anticipated.

Phaseouts are a major contributor to this issue. Certain tax benefits are gradually reduced or eliminated as income increases. For retirees, this commonly affects how much of their Social Security benefits becomes taxable. As combined income rises, up to 85% of Social Security income may be subject to tax. Because these thresholds are relatively low and not adjusted for inflation, even modest income increases can push retirees into higher effective tax rates.

Income cliffs create another challenge. Unlike phaseouts, cliffs occur when a small increase in income results in a sudden loss of a benefit or a sharp increase in costs. A well-known example is Medicare’s Income-Related Monthly Adjustment Amount (IRMAA). Exceeding an income threshold by even one dollar can lead to significantly higher Medicare Part B and Part D premiums. In this case, earning slightly more income can result in thousands of dollars in additional annual costs.

Tax credits can also disappear as income rises. While retirees may no longer qualify for certain credits tied to earned income, others, such as credits for healthcare or energy improvements, may be reduced or eliminated as income increases. Losing a credit effectively raises your tax burden, even if your tax bracket stays the same.

The result of these phaseouts and cliffs is often a higher effective marginal tax rate, meaning each additional dollar of income is taxed at a much higher rate than expected. This is why earning less doesn’t always guarantee lower taxes in retirement.

Strategic planning can help manage these risks. Coordinating withdrawals, timing income sources, and understanding thresholds in advance allows retirees to avoid unnecessary tax spikes. Retirement tax planning isn’t just about staying in a lower bracket; it’s about navigating the rules that exist between them. We will discuss these issues and more as you continue to plan your retirement years.