Most readers have by now filed their federal income tax returns, though a few, have filed extensions and have until October 16th (the 15th is on a Sunday) to file. Many retired feds will have had a nasty surprise once they saw the bottom line on their federal income tax return because, even though retirement income is taxed the same as earned income (i.e., as ordinary income), withholding can be significantly different for retirement income than it is for employment income. This is especially true of the withholding rates on TSP withdrawals. If you are one of those who ended up paying a lot (perhaps even facing the Estimated Tax Penalty), this article will give you some hints as to how to avoid owing a lot of taxes on Tax Day next year. If you’re about to retire, it will help you avoid a large payment of tax due in your first year of retirement.
The Thrift Savings Plan withholds taxes at different rates for different types of payments. They have a booklet available on their website https://www.tsp.gov/PDF/formspubs/tsp-536.pdf, that contains a detailed table describing the withholding on each different type of withdrawal. According to TSP statistics, the most common withdrawal is one called “substantially equal monthly 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 slightly over $1,700 per month before the TSP begins withholding.
How do you keep from having a nasty tax surprise with your TSP distributions?
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. During the annual open season, you could also change your withholding on form TSP-73 (the form is only available on the TSP website during the open season).
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 payment for federal income taxes.
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. If you were stuck owing a lot this year, including a penalty; make changes now so that it doesn’t happen again in the future.