By now, most of us have filed our federal and state income tax returns. Even those of us who filed an extension are required to pay what we expect our taxes to be with the extension request. I’m sure that a few of us were surprised when we saw the final numbers on our taxes, and I bet that no group of people was more surprised than those who are in their first year of retirement.
Those of us who are still working fill out a W-4 to make sure we have the proper amount withheld for taxes. We strive not to owe too much or not to get too large of a refund and, with many years of taxes under our belt, we’re pretty close to our target every year. The Tax Cuts and Jobs Act (TCJA) threw a curve to those who had large state and local tax deductions, and the larger standard deduction changed things; but that was first felt in our 2019 returns and we adjusted our withholding for 2020.
Those of us who have been retired for a while are used to the ways that the taxation of retirement income differs from the taxation of earned income. This group also was able to adjust their withholding so that they wouldn’t have too large a refund or owe too much to Uncle Sam on May 17th.
But those for whom 2020 was their first year of retirement might have ended up holding the bag and owing Uncle Sam (and maybe their state) a fair amount of money along with associated penalties for the underpayment of taxes. Read on to see how your retirement income is taxed and how you can avoid paying penalties on your taxes. You always have to pay your taxes, but, with planning, you can avoid paying penalties. Tax avoidance is, and has always been, legal. It’s tax evasion that gets folks into trouble.
Most retirees will find that they have three major sources of retirement income: 1) Their FERS annuity; 2) Social Security; and 3) the Thrift Savings Plan. Some retirees also have IRAs, annuities, or other investments as well.
Your FERS annuity is taxed as ordinary income (that is, it’s taxed based on the bracket in which it falls). Upon retirement, you were asked to complete a W-4P for federal income tax withholding and, if you live in a state that taxes retirement income, you also can fill out your state’s version of the W-4P. If you make a realistic estimate of what your taxes will be, your withholding is likely to cover the taxes on your FERS annuity. Because you made contributions towards your FERS annuity out of already taxed money, not all of your annuity will be taxable – but most of it will. Generally, the form 1099 that you receive from OPM each year will tell you what portion of your annuity is due to your contributions (not taxable in retirement) and what portion is due to Uncle Sam’s contributions and earnings from both your and Uncle’s contributions (taxable after retirement). NARFE publishes an annual list of state tax treatment in its magazine. I’ve been a NARFE member for almost 25 years and would recommend it to federal employees and, especially, retirees.
Up to 85% of your Social Security is taxable at your rate for ordinary income. But Social Security will not withhold taxes from payments unless you ask them to. Make sure that, when you apply for Social Security, you request withholding either on your application (in the remarks section) or on a form W-4V. Be aware that 13 states tax all or part of Social Security benefits. If you live in a state that taxes them, make sure to have state taxes withheld, or make estimated payments.
The Thrift Savings Plan has both traditional and Roth components. Everything you withdraw from your traditional TSP is fully taxable at your rate for ordinary income. If your Roth withdrawals are qualified, nothing you take from the Roth portion of your account is taxable. For a Roth withdrawal to be considered qualified, you must have had a Roth portion in your TSP for at least five years and you must be at least 59 ½ years of age. But beware, unless you specify otherwise, all withdrawals from the TSP are taken proportionally between the traditional and Roth portions. If there is a reason that you want to withdraw from only one portion of your TSP (e.g., under age 59 ½, desire to keep your tax bracket lower, etc.) you must specify from which part of your TSP you want the money taken.
Another thing to beware of with the TSP. The Thrift Savings Plan does not withhold for state/local taxes. If you live in a state that taxes retirement income, you should consider making estimated tax payments to your state taxing authority.
Yet one more thing to look out for when it comes to taxes and your TSP – the default withholding rate may not be nearly enough to cover the taxes due on your withdrawals. The most popular TSP withdrawal choice is installment payments and, if the installment payments are based on your life expectancy or are likely to last 10 years or more, the TSP will withhold as if you are married, filing jointly and claiming 3 dependents (see Tax Information for TSP Participants Receiving Installment Payments). This level of withholding will not nearly cover the taxes due on your withdrawals. You may (and should) specify a different withholding amount on your TSP withdrawal form.
There are a lot of tax traps that can catch unwary retirees in their first year of retirement. If you’re retiring in the near future, make sure that you know how your FERS annuity, Social Security, and (especially) your TSP are taxed and withheld.
ask.FEDweek.com: Taxes on Benefits – Federal Retirement