If 2016 will be your first year of retirement, there are a few pitfalls that might await you in the area of state and federal income taxes. However, they can be avoided with proper planning. The pitfalls involve your pension payments, Social Security and withdrawals from the Thrift Savings Plan (TSP).
As a federal retiree, your main sources of retirement income will be:
- Your federal pension, whether it is CSRS or FERS;
- Social Security; and
- The TSP.
All three of these sources are taxable as ordinary income and you can (within reason) set withholding for them. Let’s look at them one at a time and see if there’s anything we need to look out for in our first year of retirement.
Your CSRS or FERS Pension (Annuity)
When you fill out your retirement paperwork (yes, it’s still paper) you will find a W4-P among the papers. Simply fill it out with the desired level of withholding and you’re set. If you are a FERS employee who retires before the age of 62, the W4-P will also cover the payments you receive from the Special Retirement Supplement. The W4-P establishes your withholding for federal taxes. Many states also tax your annuity payment and OPM will not automatically set up state income tax withholding for you. If your state is one of those that taxes your annuity, upon receipt of your CSA number and PIN from OPM, visit their website at https://www.servicesonline.opm.gov and set up your state tax withholding. Many annuitants forget about this step and assume that OPM will automatically set up state income tax withholding, and find themselves with large tax liabilities at tax time, as well as penalties for underpayment of tax.
Social Security will not withhold federal income taxes from your benefit unless you request it. If you do not request withholding, you will find that you will owe quite a bit of money at tax time, and perhaps the 10% estimated tax penalty (ETP), as most federal retirees pay federal income tax on 85% of their Social Security retirement benefits. When you apply for Social Security fill out a form W4-V and have federal income taxes withheld from your benefits. Thirteen states also tax all or part of Social Security benefits, so be sure you have your state taxes covered if you live in Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont or West Virginia.
Thrift Savings Plan
The TSP withholds federal income taxes differently based on the way you are withdrawing your money. Monthly payments are the most popular TSP withdrawal choice, and the TSP will withhold taxes as if you had filed a W-4 claiming that you were married with three dependents. Generally, the TSP will not withhold taxes unless your monthly payment is at least $1,500 per month. If you do not change that level of withholding, you may owe quite a bit at tax time, including perhaps the ETP referred to above.
If you take money out as a single payment, the default withholding is 20%. In some instances, this will be adequate; in some, it will not.
The TSP allows you to request extra withholding; in fact there is a special section of the withdrawal form that deals with withholding.
Of course, if you withdraw Roth money from the TSP and your withdrawals are qualified, there will be no tax (and, thereby, no need to withhold taxes) from qualified Roth withdrawals.
Have federal income taxes withheld from your Social Security and Thrift Savings Plan payments.
The Estimated Tax Penalty
If you do not have enough money withheld to cover your federal income tax liability, there is a possibility that you might owe, in addition to the tax, a 10% penalty for not having enough money withheld to cover 90% of your tax bill. This is called the estimated tax penalty (ETP) and it frequently strikes those in their first year of retirement who are not aware of how taxes are withheld from their sources of retirement income.
Let’s look at a first year retiree whose filing status is single. The retiree has elected to receive monthly payments from their Traditional TSP balance; they have no Roth balance in their TSP. They have not elected additional withholding from their TSP and have not filed a W4-V to have taxes withheld from their Social Security. The retiree is receiving a $30,000 FERS pension, $18,000 in Social Security and $18,000 from their Traditional TSP for a total annual retirement income of $66,000. Withholding is set for the pension so that it covers exactly the tax liability (15% of $30,000 is $4,500); but that leaves $33,300 (The TSP and 85% of their SS) from which no taxes were withheld.
In 2016, $7,650 of the excess $33,300 would be taxed at the 15% marginal rate ($1,147.50) and the remaining $25,650 of the excess would be taxed at the 25% marginal rate ($6,412.50) for a total underpayment of $7,560. When all the math is done, this individual owes not only the $7,560 but a penalty of $635.40 (10% of the difference between 90% of the tax due and what was actually withheld).
You can’t avoid paying the taxes you owe, but you can avoid paying a penalty. Had this individual set up proper withholding, they would have another almost $650 in their bank account.
If you’re entering your first year of retirement, make sure you understand not only how your retirement income is taxed, but how it is withheld as well.