You stopped working in June. What is your actual income this year?
The year work ends is the year everything lands at once: six months of salary, a final bonus, a deferred compensation payout that has been building for a decade, and possibly a capital gain that has been deferred. The composition of income in this year is different from any year that came before it or any that will follow. The decisions available in it depend entirely on what is already landing in it.
What makes this year different from every other
The retirement year does not resemble the working years that preceded it or the retirement years that will follow it. A physician who retires in June of 2024 will report wages for half the year, possibly a performance bonus tied to the prior year, severance if the employment agreement provided for it, unused vacation paid out at termination, and a non-qualified deferred compensation distribution that may have been structured years ago with no attention to what else would land in the same year. If the practice was sold or partnership interest redeemed, a capital gain arrives as well. Each piece is taxed differently. None of it was planned to happen together.
The working years were predictable. Salary, bonus, retirement contributions, the same marginal bracket year after year. The retirement years that follow will be predictable in a different way: pension, Social Security, required minimum distributions on a schedule. The year between them is neither. It is the intersection of two calendars that were never designed to align.
The pieces and how they are taxed
Wages for the portion of the year worked are taxed as ordinary income. The final paycheck in June carries the same rate as every paycheck before it. What changes is that six months of wages will be the entire W-2 for the year, and that creates a partial-year income figure this household has not seen in decades.
A final bonus is supplemental wages, also ordinary income. Withholding on it may be at the flat 22% rate up to $1 million or the 37% rate above that, but the actual tax depends on total income for the year. A $200,000 bonus withheld at 22% may generate a balance due in April if the rest of the year pushed the household into the 32% or 35% bracket.
Deferred compensation governed by Section 409A of the Internal Revenue Code is taxed as ordinary income in the year it is distributed, regardless of when it was earned. A lump sum distribution of $500,000 from a non-qualified plan is $500,000 of ordinary income in that year. The structure of the payout was chosen years ago — lump sum, instalments over five years, delayed commencement — and the choice is binding. The plan document and the elections made under it control the timing. For specified employees of publicly traded companies, Section 409A appears to require a six-month delay after separation from service, which may push the distribution into the following tax year if retirement occurs early in the year.
A capital gain from the sale of a business or the redemption of a partnership interest is taxed at preferential rates if the asset was held for more than a year. IRS Revenue Procedure 2023-34 sets the long-term capital gains rates for 2024 at 0% on taxable income up to $94,050 for a married couple filing jointly, 15% on taxable income from $94,051 to $583,750, and 20% above that. A couple with $50,000 in wages and the $29,200 standard deduction would have $20,800 of taxable income from the wages, leaving $73,250 of room in the 0% bracket. If the only other income is a $70,000 capital gain, the entire gain is taxed at 0%. If there is also a $300,000 deferred compensation distribution, the gain is taxed at 15%, and the household is into the 24% bracket on the deferred compensation.
All of it stacks. Wages, bonus, deferred compensation and capital gains are added together to determine the marginal rate. The retirement year is the year everything that was deferred or triggered by the departure lands in a single return.
The arithmetic before the strategy
For 2024 the standard deduction for a married couple filing jointly is $29,200. The federal tax brackets are 10% up to $23,200 of taxable income, 12% from $23,201 to $94,300, 22% from $94,301 to $201,050, 24% from $201,051 to $383,900, and higher brackets above that. Taxable income is what remains after the standard deduction or itemised deductions. A household with $123,500 in total income and the $29,200 standard deduction has $94,300 of taxable income, which is the top of the 12% bracket.
The question is what fills that space. If it is all ordinary income — salary and deferred compensation — the entire amount is taxed at ordinary rates. If part of it is long-term capital gains, those gains receive preferential treatment, but only to the extent they fit below the thresholds. The 0% capital gains rate applies when taxable income is below $94,050 for a married couple in 2024. A household at the top of the 12% ordinary income bracket is also at the top of the 0% capital gains bracket. Moving $1 of ordinary income into that year moves $1 of capital gains out of the 0% rate.
This is not an argument for minimising income in the retirement year. It is an observation that the composition of income determines the tax, and the retirement year is the last year in which the composition can be influenced by the timing of a departure or the structure of a severance package.
Estimated taxes in a year that does not resemble the last one
The safe harbour rules for estimated taxes appear to allow a taxpayer to avoid underpayment penalties by paying either 90% of the current year's tax or 100% of the prior year's tax (110% if the prior year's adjusted gross income exceeded $150,000). The problem in the retirement year is that neither safe harbour reflects what is actually happening. The prior year was a full year of work. Paying 100% of that tax may be far more than required. The current year includes a deferred compensation payout that was not in the prior year. Paying 90% of the current year's tax requires knowing what the current year's tax will be, which requires knowing the amount of the deferred compensation distribution, the amount of any capital gain, and the amount of any other income, none of which may be certain in April when the first estimated payment is due.
One option is to wait until the full picture is visible and make a large estimated payment in the fourth quarter or request withholding on a year-end IRA distribution. Withholding is treated as paid evenly throughout the year for purposes of the underpayment penalty, even if it is withheld entirely in December. Estimated payments are credited to the quarter in which they are made. A household that underestimated in the first and second quarters cannot fully cure the underpayment penalty with a large third or fourth quarter payment, but it can cure it with withholding.
What this year is not
The retirement year is not the beginning of required minimum distributions. Those begin in the year after the year in which the account holder reaches age 73 for individuals born between 1951 and 1959. The first required distribution must be taken by April 1 of the year following the year the owner reaches the applicable age. Subsequent distributions must be taken by December 31 of each year. An individual who retires at 62 and was born in 1957 has eleven years before required minimum distributions begin.
The retirement year is also not the year in which Roth conversions become available. Conversions are permitted in any year. What changes at retirement is the opportunity. The working years involved earned income that filled the lower brackets and pushed additional income into higher ones. The retirement year involves a partial year of earned income. The years that follow involve pension income and eventually Social Security and required minimum distributions. The period between the end of earned income and the beginning of required minimum distributions is the window in which traditional IRA balances can be converted to Roth IRAs at rates lower than those that applied during the working years.
The retirement year is the first year of that window, not the last year before it opens. It is also the most complicated year of the window, because it includes the final payments from employment. A household that retires in June with a $300,000 deferred compensation payout arriving in July does not have a low-income year available for Roth conversions. A household that retires in June with no deferred compensation and no bonus may have exactly that. The difference is not in the decision to retire. It is in the decisions that were made years ago about how the deferred compensation would be distributed.
A rule about conversions worth holding on to
In any year in which a required minimum distribution is due, the required minimum distribution must be taken before any Roth conversion. The required minimum distribution itself cannot be converted. The IRS treats an attempt to convert the required minimum distribution as a failed conversion and an excess contribution to the Roth IRA, subject to a 6% excise tax each year it remains. This rule does not apply in the retirement year, because no required minimum distribution is due. It applies in every year after the year in which required minimum distributions begin. A retiree born in 1957 who reaches age 73 in 2030 must take the first required minimum distribution by April 1, 2031. In 2031 and every year after, the required minimum distribution comes out first. Only the amount above the required minimum distribution is available for conversion.
This is the reason the years between retirement and the beginning of required minimum distributions are described as a window. Once required minimum distributions begin, they force a distribution each year, and that distribution is taxed as ordinary income whether or not it is needed. A conversion in a year with a required minimum distribution is a conversion on top of a required distribution, and the required distribution has already filled part of the bracket.
The two-year shadow
Medicare premiums are based on modified adjusted gross income from two years prior. A large income year in 2024 affects Medicare premiums in 2026. The standard Medicare Part B premium for 2024 is $174.70 per month for individuals with modified adjusted gross income below $103,000 or couples below $206,000, based on 2022 income. Income above those thresholds triggers Income-Related Monthly Adjustment Amounts, which increase the premium in tiers. Income in the retirement year can push a household into a higher Medicare premium tier two years later, even if income in the intervening years has dropped substantially.
The premiums lag the income, and the retirement year can be the year that generates a premium increase.
The decision that was made before thinking about it
The deferred compensation payout is not a decision made in the retirement year. It is a decision made years ago when the deferral election was signed. Section 409A of the Internal Revenue Code seems to require that the form and timing of distributions be specified at the time of deferral or, for performance-based compensation with a performance period of at least twelve months, no later than six months before the end of the performance period. The election is binding. It cannot be changed once the tax year has started, except in limited circumstances involving unforeseeable emergencies or plan terminations, and those changes come with restrictions and potential penalties.
A physician who signed a deferral election in 2015 specifying a lump sum distribution upon separation from service will receive a lump sum in the year of retirement, regardless of whether that year is a good year for a lump sum. A physician who elected annual instalments over ten years will receive the first instalment in the year of retirement and one instalment each year after, regardless of what else is happening in those years. The structure is set. The retirement year inherits it.
This is the reason to review deferred compensation elections well before retirement. The question is not only how much has been deferred. It is when and in what form it will be distributed, and whether that structure aligns with the tax situation likely to exist in the retirement year and the years that follow.
How Social Security fits into it
Social Security benefits are taxable when combined income exceeds $32,000 for a married couple filing jointly or $25,000 for a single filer. Combined income is adjusted gross income plus nontaxable interest plus one-half of Social Security benefits. Below the threshold, none of the benefits are taxable. Between $32,000 and $44,000 for a married couple, up to 50% of benefits are taxable. Above $44,000, up to 85% of benefits are taxable.
The retirement year can be a high-income year, which means Social Security benefits, if taken that year, will be taxed at the 85% inclusion rate. A household with $300,000 of income and $40,000 of Social Security benefits will see 85% of the benefits — $34,000 — included in taxable income. The same household in the following year with $100,000 of income will still see 85% of the benefits taxed. The inclusion rate does not decline unless combined income drops below $44,000 for a married couple. The retirement year does not change the inclusion rate. It sets it.
Considerations worth working through
The retirement year is not the year to be surprised by the tax bill. It is the year to know, in advance, what the income will be and what the tax will be. That requires adding up the pieces: wages through the date of retirement, the amount and timing of any bonus, the structure and amount of any deferred compensation distribution, any capital gain, any severance, any payout of unused leave. The total determines the bracket. The bracket determines the value of any strategy.
If the retirement year is a low-income year by the standards of the household's working life — no deferred compensation, no large bonus, no capital gain — it may be a year in which a Roth conversion large enough to fill the 24% bracket is worth considering, or a year in which recognising a capital gain at the 0% rate becomes possible. If it is a high-income year because a $500,000 deferred compensation lump sum arrived in the same year as the final bonus, the better opportunity may be in the years that follow, when income settles at the pension and Social Security level.
The mistake is to treat the retirement year as though it will resemble either the working years or the retirement years. It resembles neither. It is a transitional year, and the decisions available in it depend entirely on what lands in it. The composition of the year was set by elections made years ago. What remains is to see it clearly and to decide what to do with the one variable still available: the timing and amount of any discretionary recognition of income or conversion of assets before the year closes.
Bottom line
The year of retirement is the year everything that was deferred or triggered by the departure arrives at once, and it is the first year of the period before required minimum distributions begin. Whether that year is an opportunity or a problem depends on what is already landing in it. The strategy depends on the arithmetic, and the arithmetic depends on decisions that were made years ago about how deferred compensation would be paid and when assets would be sold. The retirement year does not create new options. It reveals the consequences of the options that were chosen earlier.
This article describes how the federal tax rules are structured as of December 2024, not how they apply to any particular household. The composition of income in the retirement year varies by the terms of employment agreements, deferred compensation plans, and the timing of asset sales. A CPA who has reviewed the documents and the elections already on file is the one who should calculate what the retirement year will actually look like before it arrives.
Written to the law as it stood in December 2024.