After working for an entire career, many people look forward to retirement as a time during which they can worry much less about their finances. Unfortunately, the opposite is often true, and many people get caught with penalties and interest charges from the IRS because they don't have the proper amount of tax taken out of their retirement checks. Below, you'll learn how to figure out how much tax to withhold in order to cover your tax liability and avoid a nasty letter from the taxman.
Different rules for different retirement checks
Everyone's financial situation is different, and it's impossible to come up with general rules that apply in all cases. However, one key element of how much tax to take out of your check depends on what kind of retirement check you receive.
For Social Security, if you get all or the vast majority of your income from your monthly Social Security check, then there typically won't be any federal tax consequences at all, and you can safely have nothing withheld from your benefits. If you do have other income, whether it's from part-time work, investment income, or other sources, then you'll need to follow a complex formula in IRS Publication 915 that will tell you how much of your Social Security benefits will be included in your taxable income.
From that figure, you can use IRS Form 1040-ES to estimate your income tax liability for the year, and then arrange to have enough money withheld from your benefits so that the total withheld is at least 90% of your total tax for the year. Alternatively, you can have 100% of your tax liability for the previous year withheld -- or 110% if you earned more than $150,000 in the previous year -- and avoid penalties that way.
The rules are different for payments from a traditional employer pension plan. Often, workers either make no contributions toward their pension accounts or contribute money on a pre-tax basis toward their pensions. In either case, the full amount of your pension check will be included in taxable income, and you'll need to account for all of that income in calculating your estimated tax and the appropriate withholding from your pension. If, however, you've contributed after-tax money to your pension plan, then only a portion of your pension payments will be taxable.
The key thing to remember is that it's not just the income from your retirement check that determines the right amount to withhold. Unless you have tax withheld directly from your other income sources, you'll want to take those sources into account, as well, to calculate the right withholding amount.
Be smart about withholding
Finally, keep in mind that you don't have to have any money taken out of your retirement checks. If you make quarterly estimated tax payments that meet the IRS requirements, that serves the same purpose and avoids penalties.
Most people find having money withheld from their retirement checks to pay for taxes is just easier than filing a separate quarterly return. Following the above guidelines to calculate the appropriate tax withholding should make the process a lot simpler for most people to follow.
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