It’s not too early to start thinking about your 2022 federal income taxes; especially if you are planning on retiring at or near the end of 2021. The taxation of retirement income is somewhat different than the taxation of income derived from working. These changes are primarily due to how taxes are withheld on retirement income. Not only will we look at the taxation of TSP income, we’ll also take a look at how your federal annuity and Social Security are taxed.
Recently retired feds often have a nasty surprise when they see the bottom line on their first federal income tax return after retiring because withholding is, in many cases, significantly different for retirement income than it is for employment income. You want to avoid being one of those who ends up paying a lot of federal income taxes at filing time; you want to pay your taxes bit by bit over the course of the tax year.
While you’re still working you simply file a W-4 and taxes are withheld from your paycheck. You “set it and forget it”. It’s different when you retire.
Regarding your federal annuity (CSRS or FERS), you likely filled out a W-4P with your retirement papers and now taxes are being withheld from your monthly payments. You probably based this withholding on the last W-4 you filed while still an employee and it will most likely cover all taxes due from your CSRS or FERS annuity. There’s little problem here. Where it gets problematic is when we get to your Social Security and TSP withholding.
It is quite likely that 85% of your Social Security will be subject to federal income tax at your rate for ordinary income, though some retirees will find that a lesser portion is considered taxable; the higher your income the higher the percentage of your Social Security benefit that is subject to federal income tax. But Social Security will not withhold one red cent from your benefits for taxes unless you ask them to! The key to avoiding a tax surprise (particularly in your first year of retirement) is to pay the income tax on your Social Security as you go. You can:
• Ask Social Security to withhold from your monthly payments. You can do this when you apply (if you’re applying online, you do it in the “remarks” section of the form) or you can file a form W-4V after you have applied.
• Make quarterly estimated tax payments. These payments which are due on April 15, June 15, September 15 and January 15 (or a few days later depending on the day of the week the 15th falls on) require you to remember to set aside the money for the payment and remember to actually send it in. I don’t trust my memory (or my ability to keep my hands off money that I have set aside) so, when I filed for Social Security, I requested that they withhold 25% of my benefit for federal income taxes. If I don’t see it, I won’t miss it.
The Thrift Savings Plan withholds taxes at different rates for different types of payments. They have a booklet available on their website, Important Tax Information About Payments From Your TSP Account that contains a detailed table describing the withholding on each different type of withdrawal. According to TSP statistics, the most common withdrawal is installment payments and that that type of withdrawal (if the payments are like to continue for 10 years or more) is withheld as if you were married, filing jointly, and claiming 3 exemptions. Really? A CPA colleague of mine calculated that you would have to be withdrawing over $1,700 per month before the TSP begins withholding. Just because you’re not withholding doesn’t mean that you don’t owe taxes.
Most other types of payment from the TSP withhold at a 20% rate, which may (or may not) be sufficient to cover your federal income taxes.
How do you keep from having a nasty tax surprise with your TSP distributions? Pretty much the same way you would with Social Security:
• Increase the amount of withholding by completing the withholding portion of your TSP withdrawal form. If you’ve already begun distributions and want to have more withheld, you can file a W-4P.
• You could choose to make quarterly estimated tax payments, as described above in the discussion of Social Security.
Those of you who live in states that tax retirement income and/or Social Security should be aware that neither Social Security nor the TSP withhold state income taxes. You will want to either make estimated payments to your state taxing authority or have more withheld from other sources of income.
Most of us don’t like to pay taxes – but we have to. What we don’t have to do is pay penalties that result from our underpaying taxes due to the fact that we do not understand how taxes are withheld from retirement income. Forewarned is forearmed. Plan now for next year’s taxes.