Q: Now that I am retired and no longer earning a regular paycheck, how do I pay income taxes?
A: Paying income taxes is something most people rarely stop to consider. While you are working taxes are withheld from each paycheck based on your estimated tax liability for the year. Retirement income is taxed differently than earned income, but taxpayers must still prepay taxes ahead of their tax filing deadline.
There are two ways to satisfy the year-round tax payment obligation for retirement income 1) Make estimated tax payments to the IRS quarterly, or 2) Withhold taxes from benefits.
You cannot have taxes withheld from investment income such as dividends, taxable interest, and capital gains. Therefore, taxpayers may need to pay quarterly estimates. The IRS sets the date these payments are due. Due dates for 2023 are April 18, June 15, September 15, and January 15 (January 2024).
Estimated payments are based on last year’s tax liability. When adjusted gross income (AGI) is under $150,000, your estimated tax payment is equivalent to the total income tax you paid last year. For example, if your 2022 tax liability were $20,000, you would make four quarterly estimated tax payments of $5,000. If AGI was more than $150,000, your estimated tax payments must be based on 110% of your tax liability from the prior year.
Alternatively, you can base estimated payments on the current year’s tax liability. In this case, you would pay 90% of the current year’s liability in equal quarterly installments.
One final option is the annualized income installment method, in which payments are based on your actual quarterly tax liability.
Taxpayers can elect to have income taxes withheld from monthly pension and Social Security income. Use IRS Form W‑4P to elect a fixed amount or percentage to withhold from pension payments. Social Security uses IRS Form W‑4V to elect tax withholding. Federal income tax can be withheld at a rate of 7%, 10%, 12%, or 22% as of 2022 from Social Security benefits.
When you take a taxable distribution from a retirement account, you can have tax withheld by the custodian. The IRA custodian will remit the amount to the IRS and report it on Form 1099‑R at the end of the year. You can instruct the custodian to withhold up to 100% of the distribution for taxes. Withheld tax is treated as if it were paid at an even rate over the year, even if it is all paid just before the year’s end. This means that withholding on an IRA distribution taken just before the end of the year would avoid underpayment penalties.
Those taxpayers with retirement accounts may choose to cover their tax liability once they reach age 72 with their required minimum distribution (RMD). If the RMD is large enough, you can cover the entire tax bill and avoid estimated tax payments or withholding from other income sources.
As we begin a new year, work with your adviser and tax preparer to find the best strategy for your unique situation. Advisers and clients can utilize the special treatment afforded to withholdings to simplify their lives and improve outcomes.