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Dana Anspach is a Certified Financial Planner and an expert on investing and retirement planning. She is the founder and CEO of Sensible Money, a fee-only financial planning and investment firm.
Updated on August 24, 2024 In This Article In This Article
When you start a pension, you can choose to have federal and state taxes withheld from your monthly checks. The goal is to withhold enough taxes that you won't owe much money when you file your tax return. You don't want to get a large refund, either, unless you like lending money to Uncle Sam.
If you choose not to have any taxes withheld and you underpay your taxes, you could end up owing taxes plus an underpayment penalty. To avoid those fates, you'll want to estimate your income for the year and set your tax withholding appropriately.
If you are newly retired, it can be difficult to figure out how much in taxes to withhold from your pension, because your tax rate depends on your household sources of income and deductions.
When you add up all your sources of income and subtract your deductions, you get your taxable income, which determines your tax bracket. You can use this tax bracket to estimate how much to withhold. When you look at a chart of tax rates, you can see that higher amounts of income will be taxed at higher rates.
Tax planning can help you figure out the right amount to withhold. With tax planning, you put together a "pretend" tax return, called a "tax projection." As you transition into retirement, you might want to work with a CPA, tax professional, or retirement planner to help you with this.
If you prefer to do it yourself, you can plug numbers into an online 1040 tax calculator to get a rough estimate, or you can fill out your federal tax form as if you were filing taxes. Follow the instructions to see where each source of income goes. Calculate the tax you think you will owe. Divide that by your total income. Use the answer to see what percentage to withhold.
Don't forget to follow a similar process for state income taxes. Find your home state's income tax calculator or plug your income into that tax rate chart for the current year. That will get you the total taxes owed. Divide that by your income and you'll get a suggested withholding percentage. Add that percentage to your federal withholding. This way, you'll have a complete picture of your tax liability for the year.
For example, let's say your total income will be $20,000 from a pension and $30,000 that you will withdraw from your IRA. You fill out a pretend tax return and calculate that you will owe $5,000 in taxes. That is a 10% rate. You can have 10% in federal taxes withheld directly from your pension and IRA distribution so that you would receive a net $18,000 from your pension and $27,000 from your IRA.
When you are working, you can change the amount of tax withheld from your paycheck each year. In retirement, you can do that, too. When your tax situation changes, you will want to adjust your tax withholding.
For example, in your first year of retirement, you may have a salary for part of the year, and you may have a spouse who is still working, so you may need to withhold a larger amount in taxes from your pension for that year. In subsequent years, your income may change, which means you should adjust your tax withholding.
The following events may trigger a need to change your tax withholding in retirement:
Many retirees who have a pension are surprised by the increase in their taxes when they start Social Security. The amount of your Social Security benefits subject to taxation depends on your other sources of income. If your pension started a few years ago, and now you are starting Social Security benefits, you will likely need to increase your tax withholding.
When you reach age 72 or 73 (depending on your birth date), you are required to start taking distributions from traditional IRA accounts and other qualified retirement plans, such as a 401(k). These distributions are included as taxable income on your tax return. Usually, you will want to have taxes withheld from these IRA or 401(k) distributions.
Some people take an IRA distribution or cash out an old 401(k) plan early in the year and forget about it by the time they file their tax return. They are surprised by the amount of taxes they owe. Don't let this happen to you. Whenever you withdraw money from any accounts in retirement, ask about the tax implications. It is better to plan ahead than to get behind on taxes.
Pensions are fully taxable at your ordinary tax rate if you didn't contribute anything to the pension. If you contributed after-tax dollars to your pension, then your pension payments are partially taxable. If the payments start before age 59 1/2, you may also be subject to a 10% early distribution penalty.
You have to pay federal income taxes if you meet certain combined income thresholds based on your filing status. Combined income includes your adjusted gross income, nontaxable interest, and half of your Social Security benefits. For example, if you file as an individual and your combined income is between $25,000 and $34,000, you may have to pay income tax on up to 50% of your benefits. If your income is more than $34,000, you may have to pay taxes on up to 85% of your benefits. Taxes are limited to 85% of your Social Security benefits.
