Tax avoidance is OK; it is tax evasion that will get you into trouble.
As taxpayers, it is our right to take advantage of the many rules that make up the Internal Revenue Code; they were put there so that people like us could use them.
As a former IRS employee, I believe that no one should pay one penny more than they owe in federal income taxes; of course, they should not pay one penny less either.
This article is about avoiding a specific tax penalty that frequently bites retirees in their first year of retirement; the estimated tax penalty, or ETP.
Our tax system is founded on voluntary compliance with the tax laws and is set up so that we pay as we go by means of having taxes withheld from our salary. While working, most of us have enough money taken out of our paychecks to cover our tax liability and perhaps even have a little refunded to us after we file our federal income tax returns.
There is a provision in the tax code that requires that we pay in 90% of the taxes we owe by the end of the tax year (i.e., December 31st). If we do not meet the 90% requirement, not only do we owe the taxes, we also face a penalty of 10% of the difference between what we paid in and the 90% figure. So, if I owed $20,000 in federal income taxes and had paid in only $16,000 by December 31st, I will still owe $4,000 in taxes and a $200 estimated tax penalty (10% of the $2,000 by which I was under the 90% requirement). I know that I will have to pay the $4,000 worth of taxes, but I can avoid the $200 penalty if I plan right.
One reason that many first-year retirees get caught by the ETP is that two parts of our retirement income (Social Security and the Thrift Savings Plan) do not correctly withhold taxes in many situations. We’ll look at them one at a time.
Depending on your income, up to 85% of your Social Security can be subject to federal income tax and Social Security will not withhold federal income taxes from your payments unless you ask them to. I have no idea why there is not automatic withholding of a certain percentage of our Social Security payments, but there isn’t.
If 85% of the Social Security you receive this year is $22,000 and are in the 15% tax bracket, that’s $3,300 of taxes that will not have been withheld. To remedy this, you could have filed a W-4V for voluntary withholding or, if you applied for Social Security benefits online, you could have indicated the percentage you wanted withheld in the remarks section of your application.
Thrift Savings Plan
If you choose a withdrawal option other than “substantially equal monthly payments”, the withholding will likely be enough to cover your tax liability unless you are taking a large single payment. However, the most popular TSP withdrawal choice is indeed substantially equal monthly payments. As long as your payments are expected to last for ten years or more (that’ll cover most of us) you will have taxes withheld as if you were married filing jointly and claiming three dependents.
Due to my limited math skills, I consulted a colleague who is a Certified Public Accountant in order to get a handle on the amount that would be withheld if you took substantially equal monthly payments. You would have to be taking monthly payments of over $1,700 for the TSP to withhold anything from your payments. If I received $1,700 a month and was in the 15% tax bracket, I would owe $3,060 in taxes and would have had nothing withheld.
In order to avoid a nasty surprise at tax time (taxes and penalties) you should consider increasing the amount you pay in. You could choose to ask for extra taxes to be withheld from these payments, or you could make quarterly estimated tax payments. There’s no reason for you to pay penalties that you could easily avoid.