The U.S. tax system operates on a “pay-as-you-go” basis through federal income tax withholding and estimated taxes. The government generally wants their revenue as taxpayers earn their money. The government has obligations throughout the year, so I suppose this is understandable. Plus, paying in during the year is arguably good for many of us as it forces us to pay while we have the money, rather than face a large bill when tax filing time comes.
If you don’t pay the right amount of taxes at the right time, you may owe a penalty (in the form of interest). So, let’s explore how to pay the proper amount of taxes during the year in retirement and avoid the penalty.
For those working, paying taxes throughout the year is often second nature and simple for most. During one’s working years, federal income tax withholding represents the amount employers deduct from employee paychecks based on Form W-4 information.
For retirees, the game is a bit different as you generally do not have wages to withhold from (except for those lucky ones that have an ideal “second act” job in retirement that they are passionate about). Retirees generally pay their taxes throughout the year through a combination of withholding and/or estimated taxes.
Withholding for Retirees
Even though retirees usually don’t have wages to apply withholding, many retirees can withhold from their retirement plan distributions (IRAs, 401(k)s, pensions, etc.) or from their Social Security income. Typically, taxpayers can apply any rate to their retirement plan distributions, and such rate can be adjusted during the year as circumstances change.
You will need to instruct your financial institution or payer what withholding rate you want applied. If you work with a financial advisor, they may be able to help you with this if they are tax-focused advisors.
For withholding on Social Security income, you can choose to have any of the following percentages as your federal income tax withholding rate: 7%, 10%, 12%, or 22%. Note that state income tax withholding cannot be applied to Social Security income.
To apply withholding on your Social Security income, you would need to fill out Form W-4V. Then send the completed Form W-4V to your local Social Security Administration Office. To obtain this form and the address of your local Social Security Office, go to https://www.ssa.gov/manage-benefits/request-withhold-taxes.
Estimated Taxes
While withholding is a common way to pay taxes throughout the year, one can also pay Estimated Taxes over the course of the year to help avoid penalties. There are four periods during the year for which you are responsible for paying in taxes. As you earn income for that period, you generally need to pay the associated taxes.
Quarterly Payment Due Dates:
- April 15 (for income earned January-March)
- June 15 (for income earned April-May)
- September 15 (for income earned June-August)
- January 15 (for income earned September-December)
Taxpayers who have income outside of retirement plan distributions and Social Security income – like interest and dividend income, capital gain, and business income — are more likely to need to pay estimated taxes. However, you can increase your withholding mentioned above to cover the associated income taxes with these types of income. Just because you have this type of other income does not mean you have to pay estimated taxes. In fact, we generally recommend that retirees pay their taxes through withholding – either through retirement plan distributions or Social Security income. It is generally easier, and you don’t have to track down what you paid in estimated taxes throughout the year.
We often get the question of whether one should pay withholding through their retirement plan distributions or Social Security income. While I often like to see distributions made from both (to primarily even it out), it really doesn’t matter where taxes are withheld. For our clients that have not set this up when we start working with them, we often have withholding apply to retirement income distributions if they have this type of income. That makes it easier for our clients — you might consider this approach if you feel withholding through your financial provider is less of a hassle than filing with the Social Security Administration.
How to Pay Estimated Taxes
You can go old school and mail in your 1040-ES form (often called 1040 Vouchers) to the I.R.S. (with the check made out to the United States Treasury). A blank copy of 1040V can be found at https://www.irs.gov/forms-instructions. Your tax preparer may provide this for you, or if you work with a tax-focused financial planning firm that can prepare this (like our firm), you can ask your financial planner to prepare this.
You can also pay your estimated taxes online, and that is arguably the preferred method. You can either pay through your online IRS account or pay by Direct Pay if you don’t have an account established. More information can be found at www.irs.gov/Payment.
The Flexibility of Withholding Taxes Versus Paying Estimated Taxes
As I stated earlier, the government generally wants their taxes paid as the income is earned. One odd rule regarding withholding is that withholding is treated as paid ratably throughout the year regardless of when the withholding takes place. Thus, if you did not pay enough earlier in the year due to a miscalculation or whatever the case may be, you can make up for this earlier underpayment by increasing your withholding at a higher rate later in the year. In fact, you can have 100% withheld on distributions, if needed.
One planning strategy, if you want to get aggressive with this, is to intentionally not pay withholding or estimated taxes during the year and have large withholding towards the end of the year. This may have the advantage of allowing you to earn a little interest on your money.
How to Calculate My Withholding Amount
While I won’t go into detail on the tax code for this article, you will need to take into account all of your income and deductions, and your tax filing status. If you use a tax preparation firm for your taxes, they may be able to calculate this for you. Some financial planners with tax expertise (like Oasis Wealth) may also calculate this for you and provide such advice.
You can use an online calculator for these estimates. For example, you can go to the IRS website at https://www.irs.gov/individuals/tax-withholding-estimator for their tax estimator tool.
When Should You Consider Modifying Your Withholdings?
Hopefully, your calculations of your estimated taxable income and resulting tax liability are relatively accurate at the start of the year. If so, your initial withholding rates may not need to change if your income is consistent throughout the year. However, there may be cases when your withholding amounts or rates need to be adjusted.
You may want to review your withholdings and estimated taxes upon the occurrence of one of the following events:
- After major life changes (marriage, children, new job)
- When tax laws change
- New income recognition or deduction event (e.g., larger capital gains, Roth IRA conversions, large charitable gift)
- Mid-year to ensure proper withholding trajectory
Safe Harbor Provisions
Safe harbor rules protect taxpayers from underpayment penalties. The amount that you pay during the year must meet one of these conditions:
- Pay at least 90% of the tax shown on the current year’s return.
- Pay 100% of the tax shown on the prior year’s return (110% if your adjusted gross income exceeds $150,000).
The safe harbor rule based on the previous year’s tax liability offers some advantages:
- Provides a clear target for estimated payments.
- Protects against penalties even if income increases significantly.
- Simplifies tax planning for individuals with variable income.
- In years in which your prior year tax liability is lower, it may allow you to earn a little interest by not having to pay a larger amount of withholding during the year.
Penalty Amount for Underpaying Withholding or Estimated Taxes
Missing the estimated tax deadlines or paying less than the safe harbor can result in penalties calculated based on:
- The amount underpaid
- The length of time the payment was late
- The current interest rate set by the IRS
Should I Pay the Full Tax Liability or the Safe Harbor Provision?
Taxpayers are faced with the decision of whether to pay more or less for their withholding and estimated taxes. Taxpayers are of different types as far as their desire on the amount of taxes to pay. Some taxpayers want to pay more than they are estimated to owe so that they get a refund when they file their taxes. It feels like they are getting a bonus. I have seen many retirees treat this as “travel money”. Other taxpayers want to pay close to what their true tax liability is – no more or no less.
Other taxpayers strive to pay the minimum amount required by focusing on the safe harbor amount. These people would rather not give the IRS a tax-free loan – in other words, they would rather earn the interest on the money that they did not pay above the safe harbor amount. This is generally our recommended path due to that very fact. However, we recognize there are non-financial reasons for wanting to pay more than the safe harbor, and that is ok.
Don’t Forget About State Income Tax Withholding
If you live in a state that does not have income taxes, state income tax withholding does not apply. Many of our clients live in Tennessee and Florida, and those individuals do not pay state income taxes (as long as they do not have other state-sourced income). Other states that we serve (like Georgia, Alabama, and South Carolina) do have income tax withholding requirements. Some retiree income may be exempt under state rules, so caution is warranted when calculating state income taxes.
Don’t Forget About Roth Conversions, Capital Gains and Other Non-Traditional Income Sources
Many of the clients we work with implement Roth IRA Conversions. This strategy, if done correctly at the right time and for the right amounts, can be significantly beneficial for these individuals over the long term. However, taxes generally must be paid around the time the Roth IRA conversion is made (but see the discussion on the flexibility of withholding noted above). Thus, don’t forget to either pay estimated taxes or increase your withholding. We generally do not recommend having withholding apply on the Roth IRA conversion itself unless there is no other source of payments for the associated income taxes.
Capital gains is often one item that can catch taxpayers off guard. There may be the sale of real estate or stock that generates capital gains. In making your calculations for the year, it is important to understand what your potential income recognition will be for the year. Merely relying on “same as last year” may get you into trouble, but perhaps the prior year safe harbor rules may help you out.
Incorporate Tax Planning into Your Plan
Of course, we always recommend having a solid short-term and long-term strategic tax plan to reduce your income tax liability. This may include implementing Roth conversions (noted above), minimizing capital gains through tax loss harvesting, charitable planning, or capital gains tax bracket management, special charitable planning techniques, itemized deduction planning, and tax bracket management, among others.
As you go into retirement, we hope you go into retirement with confidence. Don’t let the threat of tax liabilities and tax withholding rules get in the way of sailing through retirement. If you need help, make sure you reach out to a tax preparer or a tax-focused financial planner. Should you need help with retirement planning, investment management, and tax planning, the team at Oasis Wealth would welcome the opportunity to talk with you.