For many retirees, paying taxes isn’t a one-time-a-year task. Instead, many must pay estimated taxes four times a year. The first quarterly payment is due in April, the same day as your tax return for the prior year.
If you’re still working, you probably don’t need Form 1040-ES, which you use to figure estimated taxes. Withholding on your paychecks should ensure compliance with the tax system’s pay-as-you-earn demands. But if you’re retired, chances are you need to make estimated payments. Don’t assume payments are due every three months. The payment deadlines typically fall in April, June, September and the following January. You’re basically supposed to figure how much tax you’ll owe for the current tax year and send it along to the IRS in four equal installments.
Pay at least 90% of your current tax year’s liability or 100% of what you owed the previous tax year, and you will have done your duty and be protected from an underpayment penalty. (That 100% of last year’s taxes rises to 110% if your prior year adjusted gross income was more than $150,000.)
Not only can making those estimates be a pain, writing those checks can disrupt your cash flow. Many taxpayers simply divide the previous year’s tax bill by four and send 25% on each payment date to wrap themselves in the “100% of last year’s tax bill” exception.
But depending on the source of retirement income, you may be able to satisfy the IRS via withholding from those payments. Unlike withholding from paychecks, withholding from retirement income is almost always voluntary. (The exception: Nonperiodic payouts from company retirement plans, including lump sums, are hit with 20% withholding for the IRS.)
If you want federal taxes withheld from Social Security benefits, you must file form W-4V (“V” is for voluntary) with the Social Security Administration. You can ask that 7%, 10%, 12% or 22% of each monthly benefit be carved off for the IRS. When it comes to pension or annuity payments, you control how much will be withheld by filing a Form W-4P with the payor. The worksheet for the form is like the one that Form W-4 employees use to set withholdings from wages.
For IRS distributions, the law requires that 10% be withheld for the IRS unless you tell the custodian otherwise. You can block withholding altogether or ask that as much as 100% be withheld.
A Better Way
Speaking of IRAs, a little-known opportunity may free you from withholding on multiple income sources and from the hassle of filing estimated taxes. We call it the RMD solution.
Starting at age 72, retirees must take required minimum distributions from the traditional IRAs, based on the balance in the accounts on the previous December 31 divided by a factor provided by the IRS.
If you don’t need the money to live on, wait until December to take your RMD and ask the sponsor to withhold a big chunk for the IRS, enough to cover your estimated tax on the IRA payout and all of your other taxable income for the year.
Although estimated tax payments are considered made when you send in the checks – and must be paid as your receive your income during the year – amounts withheld from IRA distributions are considered paid evenly throughout the year, even if made in a lump sum payment at year-end.
So if your RMD is large enough to cover your entire tax bill, you can keep your cash safely ensconced in the IRA most of the year, avoid withholding on other sources of retirement income, skip quarterly estimated payments…and still avoid the underpayment penalty.
Source: Kiplinger Retirement Report, February 2020