By Alan Silverstein, Fort Collins, Colorado.
Email me at ajs@frii.com.
Last update: December 27, 2020
Here are some thoughts about managing income tax withholding for retired people, at least in the US.
As best I can tell, few retired people must make quarterly estimated income tax payments (QEP, Form 1040-ES). There are other widely-available options to avoid interest and penalties without doing QEP.
I read on the web the surprising (to me) statement that any W2 or 1099 withholding done at any time throughout the year is applicable to the entire year -- which can obviate the need for QEP. I checked this out for myself by analyzing the TY2014 Form 1040 and its instructions, and it appears to be true. (Look for "Estimated Tax Penalty" buried in the document; also study various types of withholding and/or my summary later in this webpage.)
This section includes most but not all of the details underlying the three "safe harbor" rules; you must meet at least one of these three conditions; which I summarize imprecisely as:
Even if you have no W2s, most sources of 1099 income seem to provide a way to do optional withholding (at least for federal taxes). For example you can tell Social Security to do it, and it shows up on your SS-1099 form, although of course in this case the withholdings are monthly.
Another example: If you distribute from your traditional IRA at Vanguard, you can tell them to withhold up to 99% (but curiously, not less than 10%) of the withdrawal for federal taxes (but not state taxes, beware; however, apparently Fidelity does allow state withholding). Meaning if necessary you could hypothetically do a pure-withholding withdrawal on December 31 of any tax year to get into your (best-estimated) safe harbor for the whole year.
(Someone told me that at least for tIRA distributions in California, Vanguard does allow withholding state income tax. Go figure.)
(Later someone pointed out that you can also satisfy your tax withholding, late in the year, with a Roth IRA distribution that is partially or fully withheld.)
Remember to consider state income tax withholding too, in states where it matters. It's easy to overlook this. For example, Colorado's safe harbors are the same as the federal ones, except the last one is 70% not 90%. (But due to the state's lower tax rate, and generous exemption of $20K/person for taxable retirement income ($24K for age 65+), you're unlikely to owe more than $1K anyway.)
Summary of alternatives for handling tax withholding in retirement:
Note: There's no single best answer, it depends on your personal circumstances and preferences. What's important is being aware of and knowing the rules, and choosing a method that works for you. I've heard examples of people using every one of the methods below.
Or similarly as I did once, make a single early QEP payment sufficient to cover the entire year, say 100% of your previous year's net tax liability. -- It would have been simpler to just have the IRS withhold part of our refund, if I'd realized it in time. Either way, I was responsible for remembering the credit.
Do the math carefully since any traditional-IRA withdrawal raises your MAGI, tax liability, and possible ACA premium tax credits. Also beware raising your SS/Medicare MAGI sufficiently to cut your SS payments, increase your Medicare premium, etc. See also this webpage about tax efficiency.
Some particular concerns:
Your estimated tax payments for year must have been made on time and for the required amount.
This catchphrase is not elaborated in the Form 1040 instructions, but obviously it's an escape clause for the IRS in case you think you're following all the line 79 instructions but didn't do the QEP details right. (Assuming you didn't get into the safe harbors by other withholdings, and used QEP to do it, but not soon enough each quarter.)
In Colorado for example, the safe harbors appear to be similar to federal except one of them is to withhold at least 70% (not 90%) of this year's tax liability. Given a flat income tax rate of 4.63%, your net taxable income after exempting up to $20K/person of pension (and similar) taxable income would have to exceed $1000 / 4.63% = $21,598 before you'd lose the first safe harbor.
You may owe this penalty if: Line 78 is
[1] at least $1,000 and it is
[2] more than 10% of the tax shown on your return.
Those are the first two of the three safe harbors. The third safe harbor is much more complicated:
[3] You did not pay enough estimated tax by any of the due dates.
This is true even if you are due a refund.
For most people, the "tax shown on your return" is the amount on
your 2014 Form 1040, line 63, minus the total of any amounts shown
on lines 61, 66a, 67, 68, 69, and 72 and Form... (long but
irrelevant for most people).
The lines above mentioned are:
63: Total Tax 61: ACA SRP 66a: EIC 67: Additional child tax credit 68: American opportunity credit (for education) 69: Net ACA PTC (Form 8962) 72: Credit for federal tax on fuels
Exception: You will not owe the penalty if your 2013 tax return was
for a tax year of 12 full months and either of the following
applies.
1. You had no tax shown on your 2013 return and you were a U.S.
citizen or resident for all of 2013.
2. The total of lines
64 [Federal income tax withheld from Forms W-2 and 1099],
65 [2014 estimated tax payments and amount applied from 2013
return], and
71 [Excess social security and tier 1 RRTA tax withheld]
on your 2014 return is at least 100% of the tax shown on your
2013 return (110% of that amount if you are not a farmer or
fisherman, and your adjusted gross income (AGI) shown on your
2013 return was more than $150,000 (more than $75,000 if married
filing separately for 2014)).
Your estimated tax payments for 2014 must have been made on
time and for the required amount. [My emphasis.]