Many upcoming retirees aren’t quite sure how taxes in retirement are calculated. It’s not all that different than the way they are calculated while you are working. Much like when you are working, you need to have an estimate of the amount of taxes you are required to pay so you know what amount to have withheld from pensions, Social Security, or other types of income. In this article we’ll look at a series of sample calculations so you can see how to calculate your tax withholding in retirement. We look at scenarios using both 2017 and the new 2018 tax rates and rules.
The Goal – Withhold Just the Right Amount
The goal is to withhold enough taxes that you will be about break even (you won’t owe the government, but you won’t get a giant refund either).
Some people like to ‘over-withhold’ taxes, meaning they pay in more taxes than will be owed, and when they file in April they get a refund. This isn’t ideal because you are lending your money to the IRS all year. The IRS does not give you any interest on the money that you are lending them. (However, with current interest rates so low you may not be getting much interest from your bank either.)
On the other hand, if you do not have enough money withheld throughout the year (or do not pay the IRS enough in estimated payments) it is likely that you will be ‘under-withheld’ and when you file you will owe the IRS. When this happens the IRS can charge you an under-withholding penalty tax. Yikes!
It’s best if you get your tax withholding (or make estimated payments) as close as possible to your tax liability. Let’s look at a few examples to see how you can do this.
The 1040 Tax Form Once Retired
To see how taxes work once you are retired, start with the excerpt from the first page of a 1040 tax form below.
While working, when you file a 1040 tax form, if you receive a W-2 wage, the majority of your income shows up in line 7, under “Wages, salaries, tips, etc.” If you are self-employed, income will show up on line 12 for business income, and/or line 17 for real esatate and partnership income or S corp distributions.
Once retired, the majority of your income will show up where you see the orange arrows in the screenshot, in lines:
If you have investments you will also see income in line 9 (dividends) and 13 (capital gains and losses).
Start by Estimating Adjusted Gross Income
Let’s take a look at how taxes will work for a retired couple, both age 65, who are married and file jointly. We’ll call them Sam and Sara. Sam and Sara need to determine how much in taxes to have withheld from Sam’s pension during their first year of retirement.
Sam’s pension is $50,000 a year. Neither Sam or Sara have started Social Security benefits yet. In addition to their pension, for money to live on, they are using CDs that are maturing. They have $150,000 in CDs with about $30,000 maturing each year for the next 5 years. Their average interest rate is 1.5%, so this year they have about $2,250 of taxable interest income from the CDs. (Note: When a $30,000 CD matures, there is no tax due on the principal amount.)
Related: The Best Retirement Investments for a Steady Stream of Income
Here’s a snapshot of Sam and Sara’s cash flow, and gross income for taxes, which are two different things.
Sam and Sara’s Sources of Cash Flow
Their total cash flow available for the year is $82,250.
Sam and Sara’s Gross Income for Taxes During First Year of Retirement
Their total adjusted gross income (AGI) to report on their tax return is $52,250.
Next, Calculate Deductions and Taxable Income
For 2017, Sam and Sara do not itemize deductions but instead use the standard deduction and exemptions.
In 2017 the standard deduction is $6,350 each. As Sam and Sara are both age 65 or older they each get an extra $1,250 standard deduction, so $7,600 each, or $15,200 combined. They also each get a personal exemption of $4,050.
That means there is a total of $23,300 of income that is NOT taxed. You can calculate this using an online 1040 tax calculator .
Tax rates are based on your taxable income, not your AGI. Take the $52,250 of AGI less the $23,300 of deductions and exemptions and the result is $28,950 of taxable income.
In 2018, things change. There is no longer a personal exemption. In 2018, Sam and Sara would get a standard deduction of $12,000 each and an extra deduction for being age 65 or older of $1,300 each, for a total of $26,600 of income that is NOT taxed, which leaves $25,650 that is considered taxable income.
Now, Calculate Taxes Owed
Now that you have an estimate of your taxable income you can use a tax bracket schedule to see how much income will be taxed at each rate. I show examples using both the 2017 and 2018 tax rates.
For 2017 you can see that:
For 2018, it looks a bit different.
In 2017, after federal taxes, Sam and Sara have $78,840 to spend.
In 2018, after federal taxes, Sam and Sara have $79,553 to spend.
How to Calculate the Tax Withholding Rate
For 2017 taxes, take the $3,410 of total taxes owed divided by the $50,000 pension amount, and you get 6.8%. At the beginning of the year Sam and Sara should ask their pension to begin withholding 7% in federal taxes. If they have not considered this until the middle of the year, they could have 14% in taxes withheld from July through December.
If Sam does not want taxes withheld from his pension, instead they could make quarterly tax payments of $852 on April 15, June 15, September 15 of the 2017 tax year, and January 15 of the following year.
Related: Don't Leave Thousands in Social Security Survivor Benefits on the Table
How Tax Withholding Changes Later in Retirement
Now let’s look at Sam and Sara six years later. Both are receiving their full Social Security amounts, and they have required distributions from their IRAs . They have $525,000 in IRAs and they are both age 71.
To estimate tax withholding, first we have to determine the amount they are required to withdraw from their IRA . We look up their age on the Uniform Lifetime Table , and get the factor of 26.5. You take their prior year-end IRA balance of $525,000 divided by 26.5 and the resulting $19,811 is what they must take out of their IRA this year.
They spent their CDs over the last 6 years, so they have no more taxable interest income. Here’s a snapshot of their situation.
Sam and Sara’s Gross Income at Age 71
Now that they are collecting Social Security, the tax calculation requires an extra step.
There is a formula that determines how much of your Social Security is taxable. Using an online Social Security taxation calculator we estimate that $29,393 of their Social Security is taxable. The details of this formula are shown below.
Sam and Sara’s AGI at Age 71
Their AGI is $99,204. Most components of the tax code adjust with inflation. Assuming a 2% inflation rate, we estimate that in six years, Sam and Sara’s total standard deductions will be $29,956.
Take $99,204 less $29,956 and the result is $69,248 of taxable income.
Again factoring in inflation, we’ll estimate that in six years the cut off between the 10% and 12% tax rate is about $21,453.
Using $69,248 of taxable income you get the following:
Their after-tax cash flow available will be $91,324.
Next, Calculate the Tax Withholding Rate
To estimate their needed tax withholding at age 71, take $7,880 divided by the total of their pension and IRA income of $69,811 and the result is 9.9%. Here are Sam and Sara’s options for tax withholding:
Related: Why Retiring at 55 May Not Be Such a Good Idea
Our Tax Planning Services for Retirees
When we put together a retirement income plan we do a series of calculations to figure out what your tax liability will be in retirement. We gather the information that pertains to income and deductions (similar information as to what you would give your tax preparer). Then, once you retire, we set your tax withholding appropriately or tell you the amount of estimated payments to make.
Does your retirement planner incorporate tax planning into the work they do? If not, give us a call to set up a complimentary introductory meeting. Like chocolate and peanut butter, we think retirement and tax planning are better when they go together. You can learn more by watching our YouTube class, Tax Planning for Retirement.