How Much Should I Withhold for Taxes in Retirement?
Posted in: Tax Planning
Published: June 23, 2019
Many upcoming retirees aren’t quite sure how taxes in retirement are calculated. It’s not all that different than the way they are calculated while working. What is different is the way you withhold and pay those taxes.
You need to have an estimate of the amount of taxes you are required to pay so you know what amount to have withheld from pensions, Social Security, or other types of income. In this article, we’ll look at a series of sample calculations so you can see how to calculate your tax withholding in retirement. We look at scenarios using the 2019 tax rates and rules.
The Goal – Withhold Just the Right Amount
The goal is to withhold enough taxes that you will be about break even (you won’t owe the government, but you won’t get a giant refund either).
Some people like to ‘over-withhold’ taxes, meaning they pay in more taxes than will be owed, and when they file in April they get a refund. This isn’t ideal because you are lending your money to the IRS all year. The IRS does not give you any interest on the money that you are lending them. (However, with current interest rates so low you may not be getting much interest from your bank either.)
On the other hand, if you do not have enough money withheld throughout the year (or do not pay the IRS enough in estimated payments) it is likely that you will be ‘under-withheld’ and when you file you will owe the IRS. When this happens the IRS can charge you an under-withholding penalty tax. Yikes!
It’s best if you get your tax withholding (or make estimated payments) as close as possible to your tax liability. Let’s look at a few examples to see how you can do this.
The 1040 Tax Form Once Retired
To see how taxes work once you are retired, start with the excerpt from the first page of the new 1040 tax form below.
While working, when you file a 1040 tax form, if you receive a W-2 wage, the majority of your income shows up in line 1, under “Wages, salaries, tips, etc.” If you are self-employed, you may also file a Schedule C. Self-employment and other business income such as from partnerships or S corp distributions will flow through to Schedule 1, then into line 6 above.
Once retired, the majority of your income will show up where you see the orange arrows in the screenshot, in lines:
- 2a/2b – Tax-exempt and taxable interest
- 3a/3b – Qualified and ordinary dividends
- 4a/4b – IRA, pension and annuity distributions
- 5a/5b – Social Security
If you have investments that are not owned inside a retirement account you will also have capital gains and losses which are reported on Schedule 1 and flow through to line 6 above.
Start by Estimating Adjusted Gross Income
Let’s take a look at how taxes will work for a retired couple, both age 65, who are married and file jointly. We’ll call them Sam and Sara. Sam and Sara need to determine how much in taxes to have withheld from Sam’s pension during their first year of retirement.
Sam’s pension is $50,000 a year. Neither Sam or Sara have started Social Security benefits yet. In addition to their pension, for money to live on, they are using CDs that are maturing. They have $150,000 in CDs with about $30,000 maturing each year for the next 5 years. Their average interest rate is 1.5%, so this year they have about $2,250 of taxable interest income from the CDs. (Note: When a $30,000 CD matures, there is no tax due on the principal amount.)
Here’s a snapshot of Sam and Sara’s cash flow, and gross income for taxes, which are two different things.
Sam and Sara’s Sources of Cash Flow
- $50,000 pension
- $30,000 CD maturing
- $2,250 of taxable interest
Their total cash flow available for the year is $82,250.
Sam and Sara’s Gross Income for Taxes During First Year of Retirement
- $50,000 pension (goes in line 4 of the 1040)
- $2,250 taxable interest (goes in line 2b of the 1040)
Their total adjusted gross income (AGI) to report on their tax return is $52,250.
Next, Calculate Deductions and Taxable Income
For 2019, Sam and Sara do not itemize deductions but instead use the standard deduction as it is now much larger than it was prior to 2018.
In 2019 the standard deduction is $24,400 for a married couple filing jointly. As Sam and Sara are both age 65 or older they each get an extra $1,300 standard deduction, so their combined deductions are $27,000. (There is no longer a personal exemption.)
That means there is a total of $27,000 of income that is NOT taxed. You can calculate this using an online 1040 tax calculator.
Tax rates are based on your taxable income, not your AGI. Take the $52,250 of AGI less the $27,000 of deductions and the result is $25,250 of taxable income.
Now, Calculate Taxes Owed
Now that you have an estimate of your taxable income you can use a tax bracket schedule to see how much income will be taxed at each rate.
For 2019 you can see that:
- $19,400 of their income is taxed at 10%. That equals $1,940 of tax.
- The next $5,850 of their taxable income is taxed at 12%. That equals $702 of tax.
- Their total tax bill will be $2,642.
- After taxes, they have $79,609 to spend.
How to Calculate the Tax Withholding Rate
For 2019 taxes, take the $2,642 of total taxes owed divided by the $50,000 pension amount, and you get 5.3%. At the beginning of the year, Sam and Sara should ask their pension to begin withholding about 5% in federal taxes. If they have not considered this until the middle of the year, they could have 10% in taxes withheld from July through December.
If Sam does not want taxes withheld from his pension, instead they could make quarterly tax payments of $660.50 on April 15, June 15, September 15 of the 2019 tax year, and January 15 of the following year.
How Tax Withholding Changes Later in Retirement
Now let’s look at Sam and Sara six years later. Both are receiving their full Social Security amounts, and they have required distributions from their IRAs. They have $525,000 in IRAs and they are both age 71.
To estimate tax withholding, first, we have to determine the amount they are required to withdraw from their IRA. We look up their age on the Uniform Lifetime Table, and get the factor of 26.5. You take their prior year-end IRA balance of $525,000 divided by 26.5 and the resulting $19,811 is what they must take out of their IRA this year.
They spent their CDs over the last 6 years, so they have no more taxable interest income. Here’s a snapshot of their situation.
Sam and Sara’s Gross Income at Age 71
- $34,580 gross Social Security income
- $19,811 IRA withdrawal
- $50,000 pension
Now that they are collecting Social Security, the tax calculation requires an extra step.
There is a formula that determines how much of your Social Security is taxable. Using an online Social Security taxation calculator we estimate that $29,393 of their Social Security is taxable. The details of this formula are shown below.
Sam and Sara’s AGI at Age 71
- $29,393 Taxable Social Security
- $19,811 IRA Withdrawal
- $50,000 Pension
Their AGI is $99,204. Most components of the tax code adjust with inflation. Assuming a 2% inflation rate, we estimate that in six years, Sam and Sara’s total standard deductions will be $30,000.
Take $99,204 less $30,000 and the result is $69,204 of taxable income.
Again factoring in inflation, we’ll estimate that in six years the cut off between the 10% and 12% tax rate is about $22,000.
Using $69,204 of taxable income you get the following:
- The first $22,000 of income is taxed at 10%, equaling $2,200 of tax.
- The next $47,204 is taxed at 12% resulting in $5,664 of tax.
- Total federal taxes owed will be about $7,864.
Their after-tax cash flow available will be $91,340.
Next, Calculate the Tax Withholding Rate
To estimate their needed tax withholding at age 71, take $7,864 divided by the total of their pension and IRA income of $69,811 and the result is 11.2%. Here are Sam and Sara’s options for tax withholding:
- Have 11% taxes withheld from their pension and IRA distributions.
- If they want no taxes withheld from the pension, when they take their IRA withdrawal the could have 40% federal taxes withheld.
- Or, make quarterly tax payments of $1,966.
Our Tax Planning Services for Retirees
When we put together a retirement income plan we do a series of calculations to figure out what your tax liability will be in retirement. We gather the information that pertains to income and deductions (similar information as to what you would give your tax preparer). Then, once you retire, we set your tax withholding appropriately or have you make estimated payments.
Does your retirement planner incorporate tax planning into the work they do? If not, give us a call to set up a complimentary introductory meeting. Like chocolate and peanut butter, we think retirement and tax planning are better when they go together. You can learn more by watching our YouTube class, Tax Planning for Retirement.
This introduction to tax withholding is a lot to take in. If you want to learn more, check out the Control Your Retirement Destiny podcast (particularly Episode 4 on taxes) on either iTunes or Podbean.