Ready For Retirement
How to Estimate Your Tax Bill in Retirement (And How to Pay it)
David has a question about taxes in retirement: When you’re retired and no longer getting a regular paycheck from which your employer withheld tax payments on your behalf, how do you estimate the taxes you’ll owe?
To answer this question, it’s important to understand where income in retirement will be coming from and how that income is taxed. Once you have an idea of what you’ll owe, you need to make estimated tax payments throughout the year.
James explains how Social Security, withdrawals from pre-tax accounts, pensions, and brokerage accounts are taxed, and he explains how and when to make estimated tax payments to the IRS.
Questions answered:
What is the Safe Harbor Rule and how is it relevant to estimated taxes?
Is all income in retirement taxed the same?
Timestamps:
0:00 - David’s question
2:09 - Estimated tax payment options
5:28 - Back to David’s question
7:48 - Types of income – SS
11:02 - Pre-tax retirement accounts
13:53 - Average vs marginal tax rate
15:50 - Pensions
17:26 - Brokerage accounts
21:20 - How to make estimated tax payments
23:23 - Other considerations
Create Your Custom Strategy ⬇️
David has a question about taxes in retirement: When you’re retired and no longer getting a regular paycheck from which your employer withheld tax payments on your behalf, how do you estimate the taxes you’ll owe?
To answer this question, it’s important to understand where income in retirement will be coming from and how that income is taxed. Once you have an idea of what you’ll owe, you need to make estimated tax payments throughout the year.
James explains how Social Security, withdrawals from pre-tax accounts, pensions, and brokerage accounts are taxed, and he explains how and when to make estimated tax payments to the IRS.
Questions answered:
What is the Safe Harbor Rule and how is it relevant to estimated taxes?
Is all income in retirement taxed the same?
Timestamps:
0:00 - David’s question
2:09 - Estimated tax payment options
5:28 - Back to David’s question
7:48 - Types of income – SS
11:02 - Pre-tax retirement accounts
13:53 - Average vs marginal tax rate
15:50 - Pensions
17:26 - Brokerage accounts
21:20 - How to make estimated tax payments
23:23 - Other considerations
Create Your Custom Strategy ⬇️
If you're retiring soon, you might be wondering how you need to go about making tax payments once you do retire. When you're working, it's simple enough you simply have your salary, and payroll most likely will withhold most, if not all, of any potential tax liability that you have due for that calendar year. When you retire, that salary goes away, and when that salary goes away, so too do those withholdings. So how do you go about understanding how much you need to pay in taxes every year in retirement and what's the best way to go about having those taxes withheld so you don't get hit with any underpayment penalties? It's all coming up. Next, on today's episode of Ready for Retirement. This is another episode of Ready for Retirement. I'm your host, james Canole, and I'm here to teach you how to get the most out of life with your money. And now on to the episode.
Speaker 1:Today's topic comes directly from a listener question. This listener's name is David, and David writes in this. He says could you do a video discussing paying taxes in retirement? I have searched and I found a number of articles that discuss how much you pay, but none that really lay out the process of estimating them and where specifically to send the money. Can I do it all online? Do any tax prep programs help me? It'd be especially useful to learn about estimating taxes in the early years of retirement. I've seen a rule that says I should estimate based on 110% of my taxes in the year before I retire, but my wife and I will be taking significantly less income when we do retire as we are using the extra money to invest, fix up the house and generally prepare for retirement. I enjoy your videos. Thank you From David. Well, david, thank you for the kind words about the videos and yes, we will absolutely do a topic on this and that is what today's episode is for.
Speaker 1:So to go back to what I mentioned briefly in the intro, is this is sometimes something we don't think a whole lot about because when we're working, we have a salary and our payroll software assuming we input the right withholdings amounts it's just going to withhold taxes as we are paid, and so, as we get paid, the IRS is getting their money. The state if you live in a state that has income taxes is also getting theirs and that's directly withheld. So you don't have to worry about it. At the end of the year you simply need to know is there any shortfall or excess of tax payments that you made, and, if so, you deal with it at that time. But when you retire, no more salary, no more withholdings from that salary.
Speaker 1:It's a completely different game, for how you need to both estimate the taxes owed and then number two how you go about making those estimated tax payments, and there's multiple ways to do so, and we're going to talk about those ways today. To start, though, let's first understand how much you need to make in estimated tax payments, because the IRS is going to penalize you if you don't pay a sufficient amount throughout the year. So, let's say you have a tax liability of $15,000 throughout the year. Well, if you say, oh, I'll just deal with it. When tax time comes, I'll file my return, I'll report my income. The IRS says I owe $15,000 in taxes, I'll write a check for $15,000. Well, you may be hit with some tax penalties. You will be hit for penalties for not making those estimated tax payments throughout the year. The question, though, is how much should you make in estimated tax payments throughout the year? It's going to be very difficult, because we don't always know exactly what that income will look like.
Speaker 1:Well, there is something called the safe harbor rule. And the safe harbor rule is the most common way to avoid an under payment penalty. And if you're making these safe harbor payment amounts, you're generally not going to be penalized for under withholding on your taxes. So the way this works is you have one of two options. You can option number one pay 90% of any taxes you owe for the current year. Now, assuming you pay 90% of taxes you owe for the current year, that's considered a safe harbor payment. You're good to go. So, using the $15,000 in federal taxes example, if you had paid $13,500, well, that's 90% of $15,000, you would have paid a safe harbor amount and you would not pay any estimated tax penalties or underpayment penalties.
Speaker 1:The hard thing is sometimes you don't know that you owe that $15,000 until the very end of the year or even early the next year when you're actually preparing your taxes. So the IRS gives you another option. They say if you're not paying 90% of taxes that you owe for this year, you can also pay 100% of the taxes you owed for the previous year. So if this previous year you owed, say, $14,000 in taxes, well, as long as you're paying $14,000 this year, you're good to go, even if your actual tax payment is $20,000 or $30,000 or $40,000, because you paid 100% of last year's tax liability, you're not going to have an underpayment penalty. You're still going to owe the underpayment penalty. You're still going to owe the entire amount in taxes. That's not getting you out of the actual tax payment, but you wouldn't have an underpayment penalty.
Speaker 1:So, assuming you pay 100% of last year's, your previous year's tax liability this year, you're going to avoid any underpayment penalties, unless your adjusted gross income is over $150,000 or $75,000 if you're married, filing separately. If that's the case, then the 90% rule still exists of look, if you pay 90% of this year's tax liability, you're going to avoid underpayment penalties, but the amount that you would have to pay for the previous year to get that safe harbor exemption goes from 100% of last year's tax liability to 110% of last year's tax liability. So, for example, if this year I'm going to make $200,000 and I know that last year I owed $30,000 in taxes, well, if I pay 110% of last year's tax bill, so if 30,000 was my federal tax liability last year, if I pay $33,000 this year, that's my safe harbor amount. It doesn't matter if I actually owe 35 or 40 or 50 grand. I'm not going to have an underpayment penalty because I hit that 110% of previous year. So that's where you want to start.
Speaker 1:And the reason this is important is because let's actually go back to David's question. He said hey, I'm looking at all these things of how much we need to pay in taxes. It sounds like his previous year he's about to retire. His previous year tax liability might've been a bit higher. Now I'm making up some stuff or assuming some stuff that I'm maybe reading between the lines in this question. This could be off base, but it sounds like last year his tax bill is going to be much higher. His tax bill is going to be much higher because maybe he's working, there's a lot of expenses that they have, and so let's just assume his tax bill for last year is $40,000. Just pulling a number out of thin air.
Speaker 1:Well, next year David is going to retire Again. I'm making some of this stuff up, but just using it as an example. Well, when he retires, his tax liability is going to go way down because he no longer has the high income, he no longer has some of these taxable events, and let's just assume that this year his income tax liability is going to be between $5,000 to $10,000. Well, it's important for David to understand his options of he could either pay 90% of this year's expected tax liability or 110% of last year's tax liability, assuming that his adjusted gross income is under $150,000. He probably doesn't want to do the 110% option because last year his tax return or his tax liability was significantly higher. So to pay that plus an extra 10%, so 110% of last year's liability, that's going to be quite a significant tax amount. Instead, it would be more beneficial most likely in someone in a situation like that, to consider paying the 90% of this year's tax liability. It does require a bit more planning because he doesn't know exactly what that tax liability is, and that's what we're going to focus on.
Speaker 1:Next is how do you estimate that? But you can start to see what are the two options and how do you make a safe harbor payment to avoid penalties but do so in a way that's not causing you to overextend in terms of how much in estimated taxes you are paying. So that's where you start, is you start by understanding how much do you need to pay to avoid any underpayment penalties. A couple important notes is these are just general guidelines. There could be exceptions based upon your specific situation. Obviously, always talk to your financial advisor, your tax advisor, before making any specific decisions with this and another important note is this is just regarding federal taxes. Everything I've looked at Different states have different rules, so you'll have to look at your state specifically as well to understand how state taxes apply to this as well.
Speaker 1:Once you've done that, once you've understood how do you estimate your tax payment, the second thing that you need to do is understand the types of income that you have. The reason you do that is unlike a salary where it doesn't matter if you're working for company ABC or company XYZ every dollar of salary that you earn. It's taxed the exact same. It's all taxed as earned income. Well, in retirement, whether you pull money from social security or a pension or an IRA or a Roth IRA or a brokerage account or an annuity, all these are going to have different tax implications. So it's really important to understand how will each of these be taxed and what are your options for withholding taxes from that income source, so that you can make sure that you're making these tax payments throughout the year. So let's explore some of those different income types you might have in retirement, and the first of which is social security. So social security is something that almost everyone is going to have in retirement.
Speaker 1:Social security has some tax advantages, but the actual understanding of what those taxes will be can get a little bit complicated. The reason for that is because anywhere between zero and 85% of the actual income you receive from social security is included in your taxable income. Social security looks at something called provisional income, provisional income. Is this kind of formula, or it's just this type of income that you're looking at to see, based upon your provisional income, that's going to dictate what percentage of your social security benefit are you going to include in your adjusted gross income. So anywhere from 0% to 85% of it. For example, the way this works is if 50% of your Social Security benefit is included in your adjusted gross income and you are in the 10% federal tax bracket marginal federal tax bracket then the effective federal tax rate on your Social Security benefit is 5%. That makes sense, because 10% is your overall tax rate, but only half of your social security benefit is included in that. The other half is excluded. So the effective tax rate you're paying on social security is 5%.
Speaker 1:Here's the thing about social security you are able to have taxes withheld from your social security benefit, but you don't have complete flexibility as to how much social security allows you to withhold either 7%, 10%, 12% or 22% from each of your monthly payments. The way you do that is you complete IRS form W-4V and on there you indicate how much you want to have withheld in taxes. Now, with Social Security, you might have none of that that's actually subject to taxable income. You might have 85% of that that's subject to taxable income. So so much of this isn't just determined in a vacuum. You can't just look at your social security benefit and say how much should I withhold in taxes without also understanding how much you have coming in from IRAs or dividends or interest or pensions or any other income sources. So that's where it can get a little bit confusing. But know that you can withhold either 7, 10, 12, or 22% federally from your social security payment. Every state is then going to be a different story. Most states don't actually tax social security, so you don't have to withhold anything from your benefit there. Some states do, so understand what your specific state looks like. To understand both the federal withholdings and any state taxes that you need to be prepared as well. So that's social security.
Speaker 1:Next, let's talk about traditional IRAs. Now this could also apply to traditional 401ks, to traditional 403bs. Really, any pre-tax retirement account, any withdrawals that you take from an IRA which, when I say IRA, use it as a blanket term for any pre-tax retirement account any IRAs are fully taxable at the federal level, also at the state level, but some states have some unique ways in which they look at IRA withdrawals. Some exempt a certain amount of those IRA withdrawal dollars from taxation. So at the state level, look at it specifically, but at the federal level, iras are fully taxable.
Speaker 1:These, I would say, are probably the easiest to withhold taxes from, because most custodians allow you to control exactly how much you withhold for taxes at both the federal and the state level. For example, if you knew exactly what your effective tax bracket was or marginal tax bracket, depending on which way you're looking at it If you knew, okay, for every dollar I pull out of my IRA, I need to put 18% or pay 18% in federal taxes and, let's say, 7% in state taxes, well, you can indicate or you can request the custodian a custodian being like a Charles Schwab or a Fidelity or an institution like that they can withhold that payment directly for you. When they withhold that payment directly, they send that directly to the IRS and to the state if you're having state taxes withheld. So what ends up happening throughout the year is maybe you have distributed $60,000, for example, from your IRA to your bank account, so $5,000 per month and maybe you had a combined 20% withheld for taxes, so maybe 15% federal taxes and 5% in state taxes. At the end of the year that custodian is going to generate a form 1099-R. That 1099-R is going to say hey, james, here's your 1099-R for your traditional IRA.
Speaker 1:Your gross distributions were $60,000. Your federal tax withholdings were $9,000, so 15% of your gross distributions. Your state withholdings were $3,000, so 5% of $60,000. So it's giving you a report that says here's a total amount that you took out. Here was a total amount withheld. So when you either need to give that to your tax preparer, they can take that and input it into their tax preparing software, or, if you're going to use TurboTax or something like that to file your own return, you can simply plug those numbers in for the tax prep software to understand both how much you took and how much was withheld. So in a way, the nice thing about IRAs is it's kind of like a continuation of payroll, from the standpoint that when you had payroll, earned income through payroll, the withholdings were happening every single time you received income. So it wasn't something that you had to go do in terms of making an estimated payment on the IRSs or your state tax authorities website directly. It just came right out of your income.
Speaker 1:Here's the trick, though, with IRA withholdings and it's not really a trick as much as it is something that you just need to understand you do need to understand the difference between the average tax rate and your marginal tax rate. For example, let's assume that you're single in 2024 and you're taking $65,000 out of your IRA and that's your only source of income through the year. Let's also assume that you take the standard deduction. Well, at that income level, you would be in the 22% marginal federal tax bracket, meaning, if you took out $65,001, that additional dollar would be taxed at a federal rate of 22%. What that does not mean is it does not mean the entirety of that $65,000 is taxed at 22%. That $65,000 is taxed at 22%. In fact, the average tax rate on all of those $65,000 is about 8.8%. Call it 9%. Why is that? Well, some of that $65,000 was taxed at 0%. That would be the standard deduction amount. Some of it was then taxed at 10%, some of it was taxed at 12%, and then some of it was taxed at 22%. So, yes, 22% is your marginal bracket, meaning that's what you'd pay on the next dollar of income, but the average rate was right around 9%. So if you were taking $65,000 from your IRA and you were splitting that up monthly, you wouldn't want to withhold at the 22% rate. You would want to withhold at the 9% rate, because that's the average tax rate you are paying. Again, this is something you should talk to your financial advisor, your tax preparer, about, to make sure that your deductions are dialed in. This is just one arbitrary example, but making sure you understand that difference is key to making sure that you're withholding the right way. The key, though, to IRAs is understanding that they are fully taxable at the federal level, and even at many states at the state level, and that's tax. Every dollar that you earn is taxed as ordinary income Still subject, of course, to standard deductions and things like that, but IRAs are fully taxable. You do have the ability, with most custodians, to control for how much you have withheld in taxes, which is a nice benefit.
Speaker 1:The next thing I want to talk about is pensions. Now, pensions are fairly similar to IRAs. For the most part, pensions are going to be fully taxable. Now, there are some exceptions to this with government pensions, if you're, say, a disabled veteran, for example, you're going to have a tax-free VA benefit for that, but for the most part, pensions are going to be fully taxable. Same with IRAs. You're typically and this depends on the pension company able to specify the withholding on your pensions. So if you're receiving $3,000 per month and you understand your average tax rate or what that should be withheld at, you can simply elect with the pension company to have a certain percentage withheld for federal taxes, to have a certain percentage withheld for state taxes. Just like IRAs, you'll also receive a form 1099 at the end of the year. That says James, here was the total distributions from your pension and then here was the total withholdings at the federal level and state level, if applicable.
Speaker 1:I think you can probably start to see with this that one of the complexities with retirement planning when it comes to estimating taxes is most people don't just have social security or don't just have IRAs or don't just have pensions. So when you're looking at these, it's not enough to say, okay, what taxes do I owe on just my pension or just my IRA or just my social security. You need to understand the entirety of the tax picture of if you have all these income sources, what tax bracket will that put you in and then withhold accordingly from your social security benefit or from your IRA withdrawals or from your pension benefit, but pensions going back to where we are right now withdrawals or from your pension benefit, but pensions going back to where we are right now pensions pretty similar to IRAs when it comes to how you can potentially withhold taxes to make sure that you're making that estimated tax payment correctly throughout the year. Next, let's talk about brokerage accounts, and this is definitely the most challenging or confusing one to most people. So when you have a brokerage account, depending on what you are investing in, you are most likely incurring either interest or capital gains or dividends, either non-qualified or qualified dividends. Now, these are all taxable events, which is a good thing. If you weren't incurring any of them, it means your money's just not growing, it's just sitting there. But the fact that these are happening, those are taxable events, and so one of the really important things about brokerage accounts when it comes to understanding the tax impact of them is understanding what the taxable event is.
Speaker 1:Let me give you an example. You have a brokerage account with a million dollars in it and you're taking $5,000 per month. Well, that comes out to $60,000 per year. So a lot of people think, okay, I'm going to owe taxes on $60,000 per year. That's incorrect, though. That $5,000 withdrawal, that $60,000 annual withdrawal, that itself is not the taxable event. If all that million dollars was just saying cash and you took 60,000 out, none of it's taxable because you already paid taxes on all that cash.
Speaker 1:What is taxable? The actual taxable event, is the interest that's paid on that cash. It's the dividends that are paid on your stock. It's any long-term or short-term capital gains either you personally are realizing or that are being realized within any mutual funds or ETFs that you own. So that gets a lot of people hung up of. It's not the distribution that's taxable. It's the realization of gains. It's the receiving of income. That's the taxable event.
Speaker 1:Now here's the hard part about the taxable event. With something like an IRA, the taxable event is you pull money out. So if you're pulling $5,000 out per month of an IRA. That is a taxable event. And the brokerage firm so Fidelity or Charles Schwab and E-Trade, whatever it is they can have taxes withheld from that and they can pay those taxes directly to the IRS or to the state taxation authority. These firms, these brokerage firms, are typically not having taxes withheld on any interest or dividends or capital gains. So these things are all happening and even if you're not taking anything out of your account, there's taxable events happening.
Speaker 1:There's a taxable event that's going on that you need to understand so that you can understand how much to pay in taxes. So you are responsible for reporting and paying taxes on your dividends, interest, capital gains when you file taxes. Now the good news is, at the end of the year, that brokerage firm, that custodian, they're going to send you a form 1099 and there's form 1099 div. There's all these different kinds of form 1099s or tax forms. On that form it's going to say here's how much you received in interest. Here's how much you received in dividends, qualified and non-qualified. Here's any long-term gains that you realized. Here's any short-term gains that you realized. Here's any short-term gains that you realized. So they're going to fully summarize everything.
Speaker 1:The hard thing is you don't receive that until January or February, sometimes even later the following year, as a retiree understand, the IRS likes to get paid. They like for you to make your tax payments as those payments are received by you. So if your only taxable event in an entire year was what happened in your brokerage account and you weren't having anything withheld from that because the brokerage account, the custodian, they're not withholding taxes on your behalf, you might get to tax time next year and say wait a minute, I'm being hit with an underpayment penalty. Where is this coming from? Well, it might be coming from all these dividends and interest and capital gains that were happening, and even if they stayed in your account because you weren't withdrawing them, the taxable event had happened. So this is where you do need to do an estimate of what might those gains look like, what might that interest look like? Tie that into, as I mentioned before, what tax bracket might you already be in because of IRA withdrawals, pension, social security, etc.
Speaker 1:And this is where you probably need to make estimated tax payments. So the IRS has a website where you can go and you can make an estimated tax payment. These estimated tax payments are split into quarterly payments. Now they don't actually happen every three months. That would be a lot more convenient, a lot easier to track, but they're happening in April, they're happening in June, they're happening in September and then January of the following year. That's the estimated tax payment frequency, if you want to call it that, for IRS estimated taxes.
Speaker 1:So at the beginning of the year, if you're very on top of this, or maybe your financial advisor or tax preparer is really on top of this ideally you're doing an estimate of what might the next year look like. What will it look like in terms of how much I'm taking in IRA withdrawals? What will it look like in terms of how much social security myself and maybe a spouse have coming in? What will it look like if there's a property sale? What will it look like really starting to make some assumptions about what's going to happen this year so that you can get a sense of okay, what might my tax liability be for this year? My tax liability is going to be $20,000. I can make $5,000 quarterly estimated tax payments so that over the course of the year I have paid my estimated tax liability.
Speaker 1:Go back to what I started with at the beginning. There's a couple ways to determine this One is 90%. You can pay 90% of what you expect this year's tax bill to be. I shouldn't say what you expect it to be. The IRS won't care about what you expect it to be. The IRS will care about what it actually is. So if you pay 90% of this year's tax liability, you qualify for that safe harbor payment.
Speaker 1:If you don't know what this year is going to be, but you instead want to say, okay, I'm either going to pay 100% or 110% of last year's tax liability, that too counts as a safe harbor. They won't penalize you with underpayment penalties because you paid the 100% or 110% of what last year's tax bill was. So as we start to tie this all together, I do again want to emphasize that when you're making estimated tax payments, don't look at social security in a vacuum and say, okay, how much of this is going to be taxed, and then how much of my IRA is going to be taxed? Look at everything. Understand what your average tax bracket will be. Understand what your marginal tax bracket will be, because those will help inform different parts of your tax strategy.
Speaker 1:But really understanding the combined tax bracket, other considerations so things like Roth conversions, for example, you can withhold from the Roth conversion itself. So if we're talking about a tax strategy, a big one for a lot of people is Roth conversions. Let's assume you're going to do a $30,000 Roth conversion this year because you see it makes sense for your financial plan. Well, if you're in the 10% federal tax bracket, you could withhold 10% from that tax payment. $30,000 is converted. $27,000 actually makes it from the IRA into the Roth IRA. $3,000 goes right to the IRS. That's one option. So you had your taxes paid via the conversion.
Speaker 1:Ideally, in many situations you want the whole amount to be converted. So if you have $30,000 converted, you want the whole $30,000 to make it to your Roth IRA, so the whole amount can grow tax-free. And then, ideally, in many situations you're paying with cash on hand. But that does mean you need to go make an estimated tax payment. You need to go to the IRS or have some other means of withholding an extra $3,000 to account for that Roth conversion.
Speaker 1:So I say other considerations because there's other types of things people do in retirement. So maybe you're selling a property. Understand what's the tax implication of that, make an estimated tax payment. Maybe you're doing a Roth conversion. Maybe you're harvesting gains on your investment accounts. There's all these different things, and it's not quite as simple when you're retired as it is in your working years, because you don't have payroll to make these decisions for you and make these estimates for you. You have to do it, hopefully with the help of your tax preparer, financial advisor. You have to do this and you can then make the payments throughout the year to make sure you avoid any underpayment penalties. So, as always with any of these topics, there are many, many, many more details along this, but that's a high level overview of how much do you need to pay in taxes in retirement, or how do you estimate that to avoid underpayment penalties, and then an overview of how do different types of income streams in retirement get taxed. So once you understand that, you can start to understand what that looks like for you in retirement and hopefully come up with a game plan to make sure that you're staying on track with that.
Speaker 1:So that is it for today. I really appreciate that question, david. Thank you for that. Thank you to all of you who have submitted questions, who have left reviews. It really truly does help more people. So I can't tell you how many wonderful messages I get of people saying, hey, thank you for the podcast. This is really helpful information. So every time you leave a review, every time you share the podcast with a friend or family member or coworker, it really helps more people get the information they're looking for to create that more secure retirement. So thank you to all of you for listening. That is it for this time and I'll see you all next week.
Speaker 1:Hey everyone, it's me again for the disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.