How Much Should I Withhold for Taxes in Retirement?

Dana Anspach

May 21, 2020

Many upcoming retirees aren’t quite sure how to estimate taxes in retirement. It’s similar to the way you calculate taxes 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 2020 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, so when they file in April, they get a refund. Paying in more taxes than you owe 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 will owe the IRS when you file. When this happens, the IRS can charge you an under-withholding penalty tax. Yikes!

It’s best if you get your tax withholding (or 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.

When you file a 1040 tax form, if you receive a W-2 wage, the majority of your income shows up on 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 7a 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 distributions
  • 4c/4d – Pension and annuities
  • 5a/5b – Social Security

You may also have capital gains and losses from the sale of direct owned investments or real estate. These are reported on line 6. (By “direct-owned,” we mean an investment held outside of an IRA or other specific retirement account.)

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 nor Sara have started Social Security benefits yet. For additional cash flow needs, they are using CDs that are maturing. They have $150,000 in total CDs. About one CD of $30,000 each matures each year for the next five years. Their average interest rate is 1.5%, so this year they have about $2,250 of taxable interest income from 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 4c 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.

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Next, Calculate Deductions and Taxable Income

For 2020, Sam and Sara do not itemize deductions but instead use the standard deduction, as it is now much larger than it was before 2018.

In 2020 the standard deduction is $24,800 for a married couple filing jointly. Because Sam and Sara are both age 65 or older, they each get an extra $1,300 standard deduction, so their combined deductions are $27,400. (There is no longer a personal exemption.)

That means there is a total of $27,400 of income that is NOT taxed. You can calculate this using an online 1040 tax calculator.

Taxable income determines your tax rate, not your AGI. Take the $52,250 of AGI less the $27,400 of deductions, and the result is $24,850 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 the tax rates apply.

For 2020, using the table below, here are the results:

  • $19,750 of their income falls in the 10% bracket. That equals $1,975 of tax.
  • The next $5,100 of their taxable income is taxed at 12%. That equals $612 of tax.
  • Their total tax bill will be $2,587.
  • After taxes, they have $79,663 to spend.

How to Calculate the Tax Withholding Rate

Take the $2,587 of total taxes owed divided by the $50,000 pension amount, and you get 5.2%. 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, he could make quarterly tax payments of $647 on April 15, June 15, September 15 of the 2020 tax year, and January 15 of the following year.

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How Tax Withholding Changes Later in Retirement

Now let’s look at Sam and Sara eight 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 73.

To estimate tax withholding, we first have to determine the amount they are required to withdraw from their IRAs. We look up their age on the Uniform Lifetime Table and get the factor of 24.7. You take their prior year-end IRA balances of $525,000 divided by 24.7, and the resulting $21,255 is what they must withdraw from their IRA this year.

They spent their CDs over the last six years, so they have no more taxable interest income. Here’s a snapshot of their situation.

Sam and Sara’s Gross Income at Age 73

  • $34,580 gross Social Security income
  • $21,255 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. Below is a screenshot that shows you how the formula works.

Sam and Sara’s AGI at Age 73

  • $29,393 Taxable Social Security
  • $21,255 IRA Withdrawal
  • $50,000 pension

Their AGI is $100,648. Most components of the tax code adjust with inflation. Assuming a 2% inflation rate, we estimate that in eight years, Sam and Sara’s total standard deductions will be $31,474. (There is a rounding rule that we are ignoring for this example.)

Take $100,648 less $31,474 and the result is $69,174 of taxable income.

Again, factoring in inflation, we’ll estimate that in eight years, the cut off between the 10% and 12% tax rate is about $22,700.

Using $69,174 of taxable income, you get the following:

  • The first $22,700 of income is taxed at 10%, equaling $2,270 of tax.
  • The next $46,474 is taxed at 12% resulting in $5,577 of tax.
  • Total federal taxes owed will be about $7,847.

Their after-tax cash flow available will be $97,988.

Next, Calculate the Tax Withholding Rate

To estimate their needed tax withholding at age 73, take $7,847 divided by the total of their pension and IRA income of $71,255, and the result is 11%. Here are Sam and Sara’s options for tax withholding:

  • Have 11% in federal taxes withheld from their pension and IRA distributions.
  • If they want no taxes withheld from the pension, they could have 37% federal taxes withheld when they take their IRA withdrawal.
  • Or, make quarterly tax payments of $1,962.

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.ent.

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.unes or Podbean.