Paying taxes as an employee during your working years is fairly straightforward. You fill out a W-4 when you start your job and adjust it over time as your circumstances evolve. As a business owner, it’s less straightforward, but tax professionals can help you develop a routine. Regardless of your path to retirement, paying taxes in retirement is sure to throw off your routine. Some of your funds will have taxes withheld, as happened when you were working. Some will not and will have to be accounted for in the aggregate amount you pay.
I believe that most retirees who come to us and have an accountant think they must pay quarterly taxes. But it depends. Below is a three-step framework to simplify your tax life in retirement.
1. Withhold taxes where you can
Income from pensions, retirement plans, deferred compensation and Social Security can and should have taxes withheld. The mistake I see most people make with the first three income streams is that they stick with whatever the plan’s default is. If that matches your tax liability, it’s dumb luck.
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When it comes to Social Security, withholding taxes seems to be the exception because it is not required when claiming. To withhold taxes from Social Security, you must fill out a W-4V. You may think you are withholding taxes based on the amounts that are deducted for Medicare premiums before the money hits your bank account. Unfortunately, that misconception may result in an unpleasant April surprise.
At age 26, I earned my CERTIFIED FINANCIAL PLANNER™ certification. I also hold the IRS Enrolled Agent license, which allows for a unique approach to planning that can be beneficial to retirees and those selling their businesses, who are eager to minimize lifetime taxes and maximize income.
There are two advantages to withholding taxes: First, it’s easier. If you’ve ever written a quarterly estimated tax payment, you know that withholding is just an easier way to get your money to the IRS. The second is important and less known. Taxes paid via withholding are considered to be pro-rated across the calendar year. Therefore, you don’t need to worry about quarterly deadlines and the penalties associated with missing them.
2. Run a projection based on total liability
We rely on a suite of technology to project current and future tax rates for our clients. I am fully aware that running a tax projection, given the complexity of our tax code, is not simple. That said, the IRS has a few tools, as does DIY tax software. If you use an accountant, they should be able to do this for you.
Most tax preparers will base your quarterly estimates on last year’s liability. They want to “penalty-proof” your payments. This is a way to avoid underpayment penalties assessed by the IRS. You can do this by paying:
| Income | Under $150,000 | Over $150,000 |
| Option 1 | 90% of the current year liability | 90% of the current year liability |
| Option 2 | 100% of your total liability last year | 110% of your total liability last year |
However, making sure you don’t pay a penalty is not the same as running a tax projection. In an ideal world, you can make an estimate that says, “This year I expect to pay about (fill in the blank) in taxes.” With an emphasis on “about.”
If you want to access a free version of the planning software we use, which has a tax module, it’s available here.
3. Pay the difference in quarterlies
If you can say, “I think my total tax liability will be $45,000, and I’ve already withheld $25,000,” then you are going to pay the $20,000 gap via estimated payments. However, taxes in the U.S. are on a “pay-as-you-go” system, so you may not be paying $5,000 per quarter. You would make the quarterly payment in the quarter that income was received. Each quarter has a due date for the associated tax liability.
Due dates for federal estimated payments:
| First quarter | April 15, current year |
| Second quarter | June 15, current year |
| Third quarter | September 15, current year |
| Fourth quarter | January 15, next year |
It’s important to note that estimated payment due dates vary by state and will not always line up with the federal due date. Most retirees are in the habit of paying by check, but the IRS has made the online process fairly straightforward.
All the information above is tactical in nature. It is simply a framework to make sure you aren’t writing a big check, unexpectedly, in April. None of it is strategic. A strategic plan entails not only making sure that your bills are getting paid but also looking at current tax rates vs future tax rates to come up with a plan to minimize your lifetime tax bill. You can learn more about that in my article Three Keys to Keeping More of Your Money in Retirement.
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