The Problem: Paying Taxes in Retirement

Paying taxes in retirement can become a complicated piece of your retirement planning puzzle. Anyone who has ever received a paycheck knows the system in the US is pay-as-you-earn, with taxes withheld from each paycheck you receive. At the end of the year workers file taxes to balance out any amount overpaid or underpaid to the IRS.

However when you retire, this all changes. Paying taxes in retirement isn’t as straight forward and often requires you to pay estimated taxes four times a year. The payment deadlines typically fall in April, June, September, and January of the following year. The IRS requires retirees to pay 90% of their current tax year’s liability or 100% of the previous year’s liability. Failure to comply can result in an underpayment penalty (5% interest rate per month is added to under payer’s tax bill). In addition to the inconvenience of calculating and submitting payments quarterly, writing those checks can disrupt cash flow.

The Common Solution

If you are like most retired taxpayers, you simply take the previous year’s tax bill, divide by four and send that amount at each quarterly payment date. This protects you under the “100% of the previous year’s tax bill” exception (If your prior year’s Adjusted Gross Income was over $150,000, you actually need to pay 110%). Many taxpayers are able to satisfy the IRS via withholding from retirement income sources. How those withholdings work depends on the sources of retirement income. Unlike the required withholding from workers paychecks, withholding from retirement income is usually voluntary. If you want federal taxes withheld from Social Security benefits you can file a Form W-4V (V for voluntary). By filing a Form W-4P (P for payor) you can withhold taxes from pensions and annuities. For IRA distributions the baseline is set at 10% withholding. However you can block the withholding altogether or withhold as much as 100% by filing paperwork with the custodian.

As you can see, the common solution is a bit of guess work followed by a lot of paperwork. Most retirees use these patchwork withholdings yet still write a check each quarter.

A Better Way

There is a little-known strategy that can free you from withholding multiple sources of income and filing estimated taxes throughout the year. Starting at age 70 1/2, all retirees must take required minimum distributions (RMDs) from their traditional IRAs. The calculation for RMDs is taking the previous year’s balance on December 31st, and dividing by a factor provided by the IRS based on age. IRAs can withhold any amount of the distribution for taxes. Additionally, amounts withheld from IRA distributions are considered paid evenly throughout the year, even if made in a lump sum payment at year end!

So if you do not need the RMD money to live on and the RMD is large enough to cover your tax bill, you can take your RMD in December and withhold the amount required to cover taxes. This accomplishes several things: you skip quarterly payments, you avoid the underpayment penalty, avoid withholding on other income sources and you can keep the cash generating additional income for a few extra months in your IRA! Using this solution can save you tons of paperwork and improve your cash flow in retirement.

Final Word

Note that RMD withholding might not work when it comes to state taxes. Some IRA sponsors won’t withhold state income taxes. Additionally as we mentioned not all retirement income is the same. We recommend working with a CPA to ensure the strategy is right for you. At Pleasant Street Wealth Advisors we have integrated investment management and tax planning. This ensures our clients utilize the optimal investing strategy for growth and income distribution plan that fits their personal tax situation. We are passionate about sharing our knowledge and helping people maximize their wealth. If you are interested in considering the strategy discussed here for your retirement tax planning, we would love to answer your questions.