We’re coming up on the end of the year when we see if our tax planning for 2017 worked for us, and decide if we need to make any changes in our tax planning for 2018. If 2018 will be your first year of retirement, there are some pitfalls that might await you (and other first year retirees) in the area of state and federal income taxes. However, these problems can be avoided with proper planning.

As a federal retiree, your main sources of retirement income will be:

  • Your federal pension, whether it is CSRS or FERS;
  • Social Security; and
  • The TSP

All three of these sources are taxable as ordinary income and you can (within reason) set withholding for them. Let’s look at them one at a time and see if there’s anything we need to look out for in our first year of retirement.

Your CSRS or FERS Pension (Annuity)

When you fill out your retirement paperwork (yes, it’s still paper) you will find a W4-P among the papers. Simply fill it out with the desired level of withholding and you’re all set. If you are a FERS employee who retires before the age of 62, the W4-P will also cover the payments you receive from the Retiree Annuity Supplement. The W4-P establishes your withholding for federal taxes. Many states also tax your annuity payment and OPM will not automatically set up state income tax withholding for you. If your state is one of those that taxes your annuity, upon receipt of your CSA number and PIN from OPM, visit their website at https://www.servicesonline.opm.gov and set up your state tax withholding. Many annuitants forget about this step and assume that OPM will automatically set up state income tax withholding, and find themselves with large state income tax liabilities at tax time, as well as penalties for underpayment of tax.

Members of NARFE can check the NARFE website (http://www.narfe.org) for information on state income taxes. Others can consult Kiplinger’s Retiree Tax Map at http://www.kiplinger.com/tool/retirement/T055-S001-state-by-state-guide-to-taxes-on-retirees/ for information on all taxes that affect retirees.

Social Security

Social Security will not withhold federal income taxes from your benefit unless you request it. If you do not request withholding, you will find that you will owe quite a bit of money at tax time, and perhaps the 10% estimated tax penalty (ETP), as most federal retirees end up paying federal income tax on 85% of their Social Security retirement benefits. When you apply for Social Security fill out a form W4-V and have federal income taxes withheld from your benefits. If you apply for Social Security online, ask for withholding in the “remarks” section of the application.
Thirteen states also tax all or part of Social Security benefits, so be sure you have your state taxes covered if you live in Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont or West Virginia.

Thrift Savings Plan

The TSP withholds federal income taxes differently based on the withdrawal choice you make. Monthly payments are the most popular TSP withdrawal choice, and the TSP will withhold taxes as if you had filed a W-4 claiming that you were married with three dependents. Generally, the TSP will not withhold taxes unless your monthly payment is at least $1,700 per month. If you do not change that level of withholding, you may owe quite a bit at tax time, including perhaps the Estimated Tax Penalty referred to above.

If you take money out as a single payment, the default withholding is 20%. In some instances, this will be adequate; in some, it will not.

The TSP allows you to request extra withholding; in fact there is a special section of the withdrawal form that deals with withholding.

Of course, if you withdraw Roth money from the TSP and your withdrawals are qualified, there will be no tax (and, thereby, no need to withhold taxes) from qualified Roth withdrawals.

General Advice

Have federal income taxes withheld from your Social Security and have additional taxes withheld from your Thrift Savings Plan payments.

The Estimated Tax Penalty

If you do not have enough money withheld to cover your federal income tax liability, there is a possibility that you might owe, in addition to the tax, a 10% penalty for not having enough money withheld to cover 90% of your tax bill. This is called the estimated tax penalty (ETP) and it frequently strikes those in their first year of retirement who fail to have enough taxes withheld from their retirement income.

Let’s look at a first year retiree whose filing status is single. The retiree has elected to receive monthly payments from their Traditional TSP balance; they have no Roth balance in their TSP. They have not elected additional withholding from their TSP and have not filed a W4-V to have taxes withheld from their Social Security. The retiree is receiving a $30,000 FERS pension, $18,000 in Social Security and $18,000 from their Traditional TSP for a total annual retirement income of $66,000. Withholding is set for the pension so that it covers exactly the tax liability (15% of $30,000 is $4,500); but that leaves $33,300 (The TSP and 85% of their SS) from which no taxes were withheld.

Back in 2016, $7,650 of the excess $33,300 was taxed at the 15% marginal rate ($1,147.50) and the remaining $25,650 of the excess was taxed at the 25% marginal rate ($6,412.50) for a total underpayment of $7,560. In addition to the $7,560, this individual ended up owing a penalty of $635.40 (10% of the difference between 90% of the tax due and what was actually withheld).

You can’t avoid paying the taxes you owe, but you can avoid paying a penalty. Had this individual set up proper withholding, they would have another almost $650 in their bank account.

If you’re entering your first year of retirement, make sure you understand not only how your retirement income is taxed, but how it is withheld as well.