Retirement brings a multitude of changes, including adjustments to your tax obligations. While the traditional income tax system remains in place, the absence of regular paychecks can introduce complexities, particularly regarding estimated tax payments in retirement.

Who Needs Estimated Tax Payments in Retirement?

Estimated tax payments act as prepayments towards your annual federal income tax liability. They are crucial for individuals whose tax withholding from sources like pensions or Social Security falls short of their overall tax obligation. Falling short could result in penalties and interest which most taxpayers do not want to pay. Determining whether you need to make estimated payments requires understanding your potential tax sources in retirement:

Taxable Retirement Account Distributions: Withdrawals from traditional IRAs and 401(k)s are generally taxed as ordinary income. Many times, people guess their tax rate (or use the wrong tax rate) and have that percentage withheld from their retirement distributions. While this may be sufficient if their only taxable income was retirement distributions, many times it is not. If those other sources of taxable income do not allow for taxes to be withheld (for example, dividends, interest, and capital gains) then you will still owe taxes at the end of the year.

Social Security Benefits: While a portion of Social Security benefits may be tax-free depending on your total income, a portion can be taxable. If you anticipate exceeding the income threshold for tax-free benefits, you might need to make estimated payments. People do not realize that Federal taxes can be withheld from their social security payments. IRS Form W-4V can be used to have taxes withheld at anywhere from 7% to 22%.

Investment Income: Interest, dividends, and capital gains from investments can generate taxable income. Most of the time no tax is withheld from any of these sources of income. This type of income all by itself can create a need for estimated taxes, especially since capital gains can vary so much from year to year.

Rental Income: Owning rental property generates taxable income, and so unless you have additional tax withheld through social security, pension, or retirement plan distributions, you will need to make estimated tax payments.

Self-employment income: The same goes for self-employment income. The only difference between that and rental income is that income from self-employment is also subject to Social Security and Medicare tax  (referred to as SE tax) which can add an additional 12% Federal tax to your bill.

Making Estimated Tax Payments in Retirement

Once the potential tax payment shortfalls are identified the usual way that taxpayers and their tax advisors handle the shortfall is through making estimated tax payments during the year. Estimates are made four times a year (April, June, September, and the following January). Payments can be made by mailing a check to the IRS or by making payments via ACH or credit card. There are no set formulas to determine how much to pay with each estimate. The IRS offers a safe harbor provision that can help avoid penalties if your estimated payments are at least 90% of your tax liability for the current year or 100% (110% for higher income taxpayers) of the tax liability from the prior year, whichever is lower. Because of the safe harbor rules many taxpayers pay enough to cover last year’s tax. It is important to note that the term “tax liability” refers to the tax calculated on your tax return before applying any withholding or estimates made. In other words, if you got a refund last year it does not mean you can make no estimated taxes and fall under the safe harbor rule.

Avoiding Estimated Tax Payments: Exploring Alternatives

For some taxpayers, making estimated tax payments is a hassle. Remembering the dates is tricky as they do not line up with the calendar very well. The distance from the first to the second estimate is two months while the difference between the second and third is three months and the last two is four months. Who can remember that?

If you don’t want to make estimated tax payments some alternatives can reduce or eliminate penalties and interest.

Adjusting Withholding: You can increase the tax withholding on items that generally allow easily for the tax to be withheld, such as pensions, Social Security, or retirement plan distributions. It is as simple as completing a form with a higher amount to be withheld and submitting it to the custodian of your IRA or pension or the Social Security Administration. We find this to be the easiest way to make estimated tax payments and recommend them to anyone who may have to make estimated tax payments.

One benefit of doing it this way is that the IRS looks at withholding from these sources as being withheld evenly throughout the tax year. So, if you find yourself at the end of the year and you realize you are going to be short on paying your taxes – you can always increase your withholdings, (even in December) and the IRS will have deemed the extra withholding to have been paid evenly going back to January.

Applying Prior Year Refund to Current Year: Everyone loves getting a refund check from the IRS. But one way of reducing your estimated taxes and sometimes eliminating them is to apply the refund from the prior year to this current year’s payments. You won’t get a refund check, but you may not have to make all of your estimated payments either.

Tax-Efficient Withdrawals: Opting for withdrawals from Roth accounts, where contributions are made with after-tax dollars, can offer tax advantages. Since the withdrawals are not taxed, they do not contribute to your taxable income and, consequently, eliminate the need for estimated payments.

Tax-Efficient Investment Strategies: Consider tax-advantaged investments like municipal bonds, which generally offer tax-exempt interest income, minimizing your overall taxable income and potentially eliminating the need for estimated payments.

Additional Considerations

This article has focused on Federal taxes, but states have estimated tax requirements too. The state taxation of some of the income sources in retirement can be much different (usually more favorable) than at the Federal level. But states do also impose penalties and interest if not done correctly.

Making estimated payments is one of those pesky little things that if not done right can cost you a lot of money in penalties and interest. Making sure you are following the requirements and that you understand the safe harbor rules is critical to not costing you needless money. After all, once retired, you want to be able to maximize what you have.

Navigating retirement taxes can be complex, especially when dealing with diverse income sources. Consulting a qualified tax professional can provide personalized guidance and ensure you fulfill your tax obligations efficiently and effectively.

By understanding your potential tax liabilities and exploring available alternatives, you can develop a strategy for managing federal taxes in retirement that aligns with your financial goals and preferences.

We are happy to discuss with you and your tax preparer the sources of income you have and can utilize if you do not wish to make any estimated tax payments.