For most of us, during our working years we give little thought to paying taxes due on income, other than knowing that a lot of our gross pay disappears because of this. In fact our employer has set up a system to withhold what we owe automatically, so we don’t have to make the payments ourselves. So what happens when a retiree leaves the workforce and the system that has been set up to pay taxes on any income received?
Although we think of April 15 as tax day, taxes are actually due as income is earned, and employers have become the country’s primary tax collectors by withholding taxes from our paychecks. When you retire, you break out of that system: now it’s up to you to make sure the IRS gets its due when it’s due. If you wait until the following April 15 to send a check, you’re in for a nasty surprise in the form of penalties and interest.
You have two ways to get the job done:
Withholding. Withholding isn’t only for paychecks. If you receive regular payments from a company pension or annuity, the payers will withhold tax. . . unless you tell them not to. The same goes for withdrawals from an IRA. That’s right: in retirement, it’s up to you whether part of the money will be proactively skimmed off for the IRS.
With pensions and annuity payments, taxes will be withheld unless you file a Form W-4P to put the kibosh on it. When it comes to traditional IRA distributions, withholding will be at a flat 10% rate, unless you request a different rate or block withholding all together. Things are topsy-turvy with Social Security benefits. There will be no withholding unless you specifically ask for it by filing a Form W-4V.
Withholding isn’t necessarily a bad thing, as it stretches your tax bill over the entire year. It might also make life easier if you would otherwise have to make quarterly estimated tax payments.
Quarterly estimated tax payments. The alternative to withholding is to make quarterly estimated tax payments. You need to if you’ll owe more than $1,000 in tax for the year above and beyond what’s covered by withholding. Otherwise, you’ll face a penalty for underpayment of taxes.
Consult with your tax person or financial advisor to see what the best route is for your situation. Either way the government will get what it is owed, just make sure you don’t have to pay extra in the form of penalties and interest because you did nothing.