When you start a pension you can choose to have federal and state taxes withheld from your monthly pension checks. The goal is to withhold enough taxes that you won't owe much money when you file your tax return, nor will you get a large refund.
I know some people like to withhold extra money because they like getting a large refund each year. You can do this, but keep in mind, by doing so you are lending money to the government all year long.
Other people may choose not to have any taxes withheld, but if you underpay your taxes, you could end up owing taxes plus an underpayment penalty. To avoid this, you'll want to estimate your income for the year, and set your tax withholding appropriately.
How Much in Taxes Should You Withhold?
If you are newly retired it can be difficult to figure out how much in taxes to withhold from your pension. It depends on your other sources of income and your deductions.
When you add up all your sources of income and subtract out your deductions you get your taxable income. Your taxable income determines your tax bracket and you can use this tax bracket to estimate how much to withhold. When you look at a chart of tax rates (i.e. tax brackets) you can see that higher amounts of income will be taxed at higher rates.
Tax planning can help you figure out the right amount to withhold. With tax planning you put together a "pretend" tax return, called a tax projection. Here are three ways to do your year end tax planning. As you transition into retirement you might want to work with a CPA or tax professional to help you with this.
When to Change How Much Tax is Withheld from Your Pension
When you are working you can change the amount of tax withheld from your paycheck each year. In retirement, you can do this too. When your tax situation changes you will want to adjust your tax withholding.
For example, your first year of retirement you may have had a salary part of the year, and you may have a spouse who is still working. This means you may need to withhold a larger amount of your pension for taxes. In subsequent years, your income may change, which means you should adjust your tax withholding.
The following events may trigger a need to change your tax withholding in retirement:
- Spouse stops working
- You or a spouse take on part-time work
- You pay off a mortgage, or take on a mortgage
- You have a large amount of taxable capital gains from the sale of a property, mutual funds, or stock
- You take withdrawals from an IRA or 401(k) account
- You or a spouse start Social Security benefits
Change in Withholding When You Start Social Security
Many retirees who have a pension are surprised by the increase in their taxes when they start Social Security. The amount of your Social Security benefits subject to taxation depends on your other sources of income.
If you began a pension and later start Social Security benefits you will likely need to increase your tax withholding.
Change in Withholding When You Reach Age 70
When you reach age 70 ½ you are required to start taking distributions from traditional IRA accounts and other qualified retirement plans like a 401(k). These distributions are included as taxable income on your tax return. You may want to have taxes withheld from these IRA/401(k) distributions, or you could increase the tax withholding from your pension. It will be easiest, however, to have the taxes withheld from the retirement plan distributions as you take them.
Some people take an IRA distribution or cash-out an old 401(k) plan early in the year and forget about it by the time they file their tax return. They are then surprised by the amount of taxes they owe. Don't let this happen to you. Whenever you withdraw money from any accounts in retirement ask about the tax implications. It is better to plan ahead than to get behind on taxes.