As you transition into retirement, managing your taxes is one of the biggest challenges you’ll face. Retirees must be more proactive (or use an advisor 😊) than when you were working and had taxes automatically withheld from your paycheck. This is where understanding the difference between the income you spend and, for tax planning reasons, the income you create/realize via Roth conversions, gain harvesting, etc. on your return.

 

Paying Taxes in Retirement: Your Withholding Options

In retirement, you have several options for paying taxes. Whether through Social Security, pension payments, or retirement account distributions, you can withhold federal, and in some cases state, taxes directly from these sources. Another option is to make estimated quarterly tax payments based on your expected annual tax liability either using the slips usually included with your tax return or by setting up electronic payments at the federal and state levels.

Here are the options for paying taxes as a retiree:

1. Withholding from Social Security: You can elect to have federal taxes (only) withheld from your Social Security benefits.
2. Withholding from Pension payments: Pension payments typically allow both state and federal withholding.
3. Withholding from 401k/403b/IRAs: Distributions from these accounts can be withheld and remitted directly as tax payments. The best part is that tax payments made this way are treated as if payments were made throughout the year.
4. Making Estimated Tax Payments: You can also make quarterly estimated tax payments by mailing slips included with your tax return or by making electronic payments online. In contrast to #3, you’ll need to do this each quarter. The slips aren’t foolproof.

 

The Difference Between Spending Money and Taxable Income

Many retirees make the mistake of thinking the money they spend each month directly translates to what shows up on their tax returns. Understanding the difference between “income” and “tax return income.”

• Income or Spending Money: This refers to any money you receive monthly to cover your living expenses, such as Social Security, pensions, or retirement distributions. While this money supports your lifestyle, it doesn’t necessarily correlate with your taxable income.
• Tax Return Income: This is the amount on your tax return. Factors such as deductions, credits, and the source of your income (pre-tax vs. post-tax) impact what is considered taxable. The goal is to manage your taxable income strategically, as you may be able to reduce your tax liability or, in some cases, increase it if it’s too low.

For example, if your tax return income is very low, it might make sense to take additional distributions from a retirement account to fill up lower tax brackets without triggering higher tax rates.

 

Safe Harbor Rules: Avoid Penalties and Interest

One of the most important concepts to grasp as a retiree is the safe harbor rules.

• What is Safe Harbor? Put simply, a safe harbor is the amount you need to pay and when you need to pay it to avoid penalties and interest. It is not your tax liability. If you’re doing it right, you’ll almost always “owe” when you file your taxes. All that means is you paid the government what they were owed when they were owed it.
  • What are the Safe Harbor rules? The federal safe harbor rules are:
  • Pay 100% of your last year’s total tax liability (110% if your AGI was more than $150,000), or
  • 90% of your current year’s actual tax liability. This is a far more difficult number to determine, primarily because of year-end mutual fund dividends and distributions.

To avoid underpayment penalties and interest.  This gives retirees a clear goal for how much to pay in taxes throughout the year. States generally operate with the same safe harbor rules.

 

Self-Employment or Part-Time Employment in Retirement

Many retirees continue to earn income through self-employment or part-time work. While this can provide a great financial cushion, it adds complexity to your tax situation. Self-employment income is subject to both income taxes and self-employment taxes (Social Security and Medicare). Here’s what you need to know:

• Withholding Taxes and Self-Employment: If you’ve already had taxes withheld from your Social Security or retirement distributions, these can help offset your self-employment taxes. However, the safe harbor rule does not take into account the self-employment tax due, which can lead to an underpayment situation if you’re not careful.
• Estimated Tax Payments: In this case, making estimated tax payments becomes crucial. You’ll need to ensure that your quarterly payments cover both income and self-employment taxes. It’s easy to make mistakes here, so it’s often best to seek the advice of a CPA to ensure everything is accounted for.

 

Remember that getting a full picture of your withholding options is a big reason your financial advisor wants to look at your tax return every year. Knowing your options means looking at a multi-year time frame, but it is an every-year decision – and we’re here to help. CLICK HERE to make an appointment.