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Two things in life are certain – death and taxes – one we have very little control over and the other some control over, possibly even more in retirement.

Retirement is a different situation than our working years because financial psychology changes from the accumulation phase to a distribution phase. The distribution phase often has different streams of income from distinctly different sources than those while the employee was working. As a result, taxation can and will change.

Withholding can be tricky

Those changing sources of income can come with different withholding for state and federal taxes. Withholding is simply the amount of money taken out of your check (FERS annuity for example) that is sent to the government for your tax payment. The three common sources of retirement income are FERS annuity, Social Security and TSP or IRA distributions. Individually, these sources are somewhat unique in taxation but still considered taxable income.

One question that new retirees often have is, “how much should I have withheld from my FERS Annuity and Social Security?” What about withholding from IRAs and TSP?

There are two important reasons get your withholding right in retirement:

1. Avoiding any penalties and interest to the IRS
2. Not getting surprised with a large tax bill

You want to get number one right because if you don’t, you could owe a penalty and interest on the underpayment and the penalty amount. For most retirees I would estimate the penalty and interest payment to be somewhat small, but that would depend on the amount of underpayment. It would be ideal to not owe any penalties or interest at all.

The second reason could be more serious than the first. I have seen retirees get to the end of the year and have an underpayment of $10,000 or more. While you would think the $10,000 would be somewhat easy to come up with in retirement, that isn’t always the case. Psychologically nobody wants to get hit with a $10,000 bill, especially a tax bill, and then have to figure out where that money is going to come from.

How do you get withholding right?

The best way I have found is to check your withholding when you are about three quarters of the way through the year. You may want to check it earlier, but if so, you should check again later in the year.

The amount you want to have withheld is what is known as a “Safe Harbor” rule for tax withholding. As long as you meet the requirement for this rule, you won’t owe any penalties for underpayment, as follows:

• If your Adjusted Gross Income (AGI) is under $150,000, you must pay at least 90% of the tax you owe for the current year, or 100% of the tax you owed for the previous year.
• If your adjusted gross income is over $150,000, you must pay the lower of 90% of the tax for the current year or 110% of the tax owed for the previous year.

Keep in mind that these withholding rules are for federal tax and there may be separate rules that apply to state income tax. Rules vary by state.

To check your withholding, you can work with your accountant, financial advisor, or do it yourself using an online calculator. One of the better free calculators that I have used is the Dinkytown 1040 calculator.

For your calculation, you need to check your income and taxes withheld to date, and then estimate out through the end of the year. Input those numbers into the calculator to see what your total tax will be for the year. If you are not on track to have enough withheld, then you need to make an adjustment.

Adjustment options

If you find that you will be short on tax withholding, you have a few options:

• Contact OPM and change the withholding on your FERS annuity.
• Change withholding on your Social Security (if you are collecting).
• Have more withheld from TSP or IRA distributions.
• Make a tax payment directly to the IRS.

Regardless which option you choose, you will want to make some adjustments for the next year. After you have finished one year of retirement you should have a better idea of how much tax you will owe the following year.

There are a few things that can throw your income taxes off from year to year.

• Annual leave payout in the first year of retirement
• starting to collect Social Security
• taking higher than normal IRA distributions (which can also cause Social Security to get taxed at a higher rate)

Checking your withholding is most important in your first year of retirement, but it’s a good exercise to do toward the end of each year. It’s even more important to do in years where you have a big change in income.

The amount of money you pay in taxes and checking tax withholding are just more pieces to your financial puzzle. If you find yourself overwhelmed with challenges like tax withholding and would like a partner on your financial journey you are welcome to schedule a call.

Brad Bobb, CFP® is the owner of Bobb Financial Inc, and an expert in retirement planning for federal employees. 

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