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Estimate bill format for Planning

if you're retiring soon you might be wondering how you need to go about making tax payments once you do retire when you're working it's simple enough you simply have your salary and payroll most likely will withhold most if not all of any potential tax liability that you have due for that calendar year Well you when you retire that salary goes away and when that salary goes away so too do those withholdings so how do you go about understanding how much you need to pay in taxes every year in retirement and what's the best way to go about having those taxes withheld so you don't get hit with any underpayment penalties it's all coming up next on today's episode of ready for retirement today's topic comes directly from a listener question this listener's name is David and David writes in this he says could you do a video discussing paying taxes in retirement I've searched and I found a number of articles that discuss how much you pay but none that really lay out the process of estimating them in where specifically to send the money can I do it all online do only tax prep programs help me it'd be especially useful to learn about estimating taxes in the early years of retirement I've seen a rule that says I should estimate based on 110 % of my taxes in the year before I retire but my wife and I will be taking significantly less income when we do retire as we are using the extra money to invest fix up the house and generally prepare for retirement I enjoy your videos thank you from David well David thank you for the kind words about the videos and yes we will absolutely do a topic on this and that is what today's episode is for so to go back to what I mentioned briefly in the intro is this is sometimes something we don't think a whole lot about because when we're working we have a salary and our payroll software assuming we input the right withholdings amounts it's just going to withhold taxes as we are paid and so as we get paid the IRS is getting their money uh the state if you live in a state that has income taxes is also getting their and that's directly withheld so you don't have to worry about it at the end of the year you simply need to know is there any shortfall or excess of tax payments that you made and if so you deal with it at that time but when you retire no more salary no more withholdings from that salary it's a completely different game for how you need to both estimate the taxes owed and then number two how you go about making those estimated tax payments and there's multiple ways to do so and we're going to talk about those ways today to start though let's first understand how much you need to make an estimated tax payments because the IRS is going to penalize you if you don't pay a sufficient amount throughout the year so let's say you have a tax liability of 15,000 throughout the year Well if you say oh I'll just deal with it when tax time comes you know I'll file my return I'll report my income the IRS has a15 ,000 in taxes or write a check for $115,000 well you may be hit with some tax penalties you will be hit for penalties for not making those estimated tax payments throughout the year the question though is how much should you make an estimated tax payments throughout the year it's going to be very difficult because we don't always know exactly what that income will look like well there is something called The Safe Harbor Rule and the Safe Harbor rule is the most common way to avoid an underpayment penalty and if you're making these Safe Harbor payment amounts you're generally not going to be penalized for underwithholding on your taxes so the way this works is you have one of two options you can option number one pay 90% of any taxes you owe for the current year now assume you pay 90% of taxes you owe for the current year that's considered a safe harbor payment you're good to go so using the $155,000 in federal taxes example if you had paid $3,500 well that's 90% of 15,000 you would have paid a safe harbor amount and you would not pay any estimated tax penalties or underpayment penalties the hard thing is sometimes you don't know that you owe that $155,000 until the very end of the year or even early the next year when you're actually preparing your taxes so the IRS gives you another option they say if you're not paying 90% of taxes that you owe for this year you can also pay 100% of the taxes you owed for the previous year so if this previous year you owed say1 14,000 in taxes well as long as you're paying $14,000 this year you're good to go even if your actual tax payment is 20,000 or 30,000 or 40,000 because you paid 100% of last year's tax liability you're not going to have an underpayment penalty you're still going to owe the entire amount in taxes that's not getting you out of the actual tax payment but you wouldn't have an underpayment penalty so assuming you pay 100% of last year's your previous year's tax liability this year you're going to avoid any underpayment penalties unless your adjusted gross income is over $150,000 or $75,000 if you're married fining separately if that's the case then the 90% Rule still exists of look if you pay 90% of this year's tax liability you're going to avoid underpayment penalties but the amount that you would have to pay for the previous year to get that Safe Harbor exemption goes from 100% of last year's tax liability to 110% of last year's tax liability so for example if this year I'm going to make $200,000 and I know that last year I owed $30,000 in taxes well if I pay 110% of last year's tax bill so if 30,000 was my federal tax liability last year if I pay $33,000 this year that's my Safe Harbor amount it doesn't matter if I actually owe 35 or 40 or 50 Grand I'm not going to have an underpayment penalty because I hit that 110% of previous year so that's where you want to start and the reason this is important is because let's actually go back to David question he said hey I'm looking at all these things of how much do I need to pay in taxes it sounds like his previous year if he's about to retire his previous year tax liability might have been a bit higher now I'm making up some stuff or assuming some stuff that I'm maybe reading between the lines in this question this could be off base but it sounds like last year his tax bill is going to be much higher his tax bill is going to be much higher because maybe he's working there's a lot of expenses that they have and so let's just assume his tax bill for last year is $440,000 just pulling a number out of thin air well next year David is going to retire again I'm making some of the stuff up but just using it as an example well when he retires his tax liability is going to go way down because he no longer has the high income he no longer has some of these taxable events and let's just assume that this year his income tax liability is going to be between $5 to $10,000 well it's important for David to understand his options of he could either pay 90% of this year's expected tax liability or 110% of last year's tax liability assuming that his adjusted gross income is under $150,000 he probably doesn't want to do the 110% option because last year his tax return or his tax liability was significantly higher so to pay that plus an extra 10% so 110% of last year's liability that's going to be quite a significant tax amount instead it would be more beneficial most likely in someone in a situation like that to consider paying the 90% of this year's tax liability does require a bit more planning because he doesn't know exactly what that tax liability is and that's what we're going to focus on next is how do you estimate that but you can start to see what are the two options and how do you make a safe Harware payment to avoid penalties but do so in a way that's not causing you to overextend in terms of how much an estimated taxes you are paying so that's where you start is you start by understanding how much do you need to pay to avoid any underpayment penalties couple important notes is these are just general guidelines there could be exceptions based upon your specific situation obviously always talk to your fin financial adviser your tax adviser before making any specific decisions with this and another important note is this is just regarding federal taxes everything I've looked at different states have different rules so you'll have to look at your state specifically as well to understand how state taxes apply to this as well once you've done that once you've understood how do you estimate your tax payment the second thing that you need to do is understand the types of income that you have the reason you do that is unlike a salary where it doesn't matter if you're working for company ABC or company XYZ every dollar of salary that you earn it's taxed the exact same it's all taxed as earned income well in retirement whether you pull money from Social Security or a pension or an IRA or a Roth IR or a brokerage account or an annuity all these are going to have different tax implications so it's really important to understand how will each of these be taxed and what are your options for withholding taxes from that income source so that you can make sure that you're making these tax pay pays throughout the year so let's explore some of those different income types you might have in retirement and the first of which is social security so Social Security is something that almost everyone is going to have in retirement social security has some tax advantages but the actual understanding of what those taxes will be can get a little bit complicated the reason for that is because anywhere between 0 and 85% of the actual income you receive from Social Security is included in your taxable income Social Security looks at something called provisional income provisional income is this kind of formula or just this type of income that you're looking at to see based upon your provisional income that's going to dictate what percentage of your social security benefit are you going to include in your adjusted gross income so anywhere from 0 to 85% of it for example the way this works is if 50% of your social security benefit is included in your adjusted gross income and you are in the 10% federal tax bracket marginal federal tax bracket then the effective federal tax rate and your social security benefit is 5% that makes sense because 10% is your overall tax rate but only half of your social security benefit is included in that the other half is excluded so the effective tax rate you're paying on Social Security is 5% here's the thing about social security you are able to have taxes withheld from your social security benefit but you don't have complete flexibility as to how much Social Security allows you to withhold either 7% 10% 12% or 22% from each of your monthly payments the way you do that is you complete IRS form w-4v and on there you indicate how much you want to have withheld in taxes now with Social Security you might have none of that that's actually subject to taxable income you might have 85% of that that's subject to taxable income so so much of this isn't just determined in a vacuum you can't just look at your social security benefit and say how much should I withhold in taxes without also understanding how much you have coming in from IAS or dividends or interest or pensions or any other income sources so that's where it can get a little bit confusing but know that you can withhold either 7 10 12 or 22% federally from your Social Security payment every state is then going to be a different story Most states don't actually tax Social Security so you don't have to withhold anything from your benefit there some states do so understand what your specific state looks like to understand both the federal withholdings and any state taxes that you need to be prepared as well so that's Social Security next let's talk about traditional IRAs now this could also apply to traditional 401ks to traditional 403bs really any pre-tax retirement account any withdrawals that you take from an irra which when I say Ira using as a blanket term for any pre-tax retirement account any IAS are fully taxable at the federal level also at the state level but some states have some unique ways in which they look at Ira withdrawals some exempt a certain amount of those IRA withdrawal dollars from taxation so at the state level look at it specifically but at the federal level IRAs are fully taxable these I would say are probably the easiest to withhold taxes from because most custodians allow you to control exactly how much you withhold for taxes at both the federal and the state level for example if you knew exactly what your effective tax bracket was or marginal tax bracket depending on which way you're looking at it if you knew okay for every dollar I pull out on my IRA I need to put uh 18% or pay 18% in federal taxes and let's say 7% in state taxes well you can indicate or you can request the custodian a custodian being like a Charles Schwab or a Fidelity or an institution like that they can withhold that payment directly for you when they withhold that payment directly they send that directly to the IRS and to the state if you're having state taxes withheld so what ends up happening throughout the year is maybe you have distributed $660,000 for example from your IRA to your bank account so $5,000 per month and maybe you had a combined 20% withheld for taxes so maybe 15% federal taxes and 5% in state taxes at the end of the year that custodian is going to generate a form 1099r that 1099r is going to say hey James here's your 1099r for your traditional IRA your gross distributions were $60,000 your federal tax withholdings were $9,000 so 15% of your gross distributions your state withholdings were $3,000 so 5% of $60,000 so it's giving you a report that says here was a total amount that you took out here was a total amount withheld so when you either need to give that to your tax preparer they can take that and input it into their tax preparing software or if you're going to use Turbo Tax or something like that to file your own return you can simply plug those numbers in for the tax prep software to understand both how much you took and how much was withheld so in a way the nice thing about IA is it's kind of like a continuation of payroll from the standpoint that when you had payroll earned income through payroll the withholdings were happening every single time you received income so it wasn't something that you had to go do in terms of making an estimated payment on the irs's or your state tax authorities website directly it just came right out of your income here's the trick though with IRA withholdings and it's not really a trick as much as it is something that you just need to understand you do need to understand the difference between the average tax rate and your marginal tax rate for example let's assume that you're single in 2024 and you're taking $65,000 out of your IRA and that's your only source of income through the year let also assumed that you take the standard deduction well at that income level you would be in the 22% marginal federal tax bracket meaning if you took out $65,000 $1 that additional dollar would be taxed at a federal rate of 22% what that does not mean is it does not mean the entirety of that $65,000 is taxed at 22% in fact the average tax rate on all of those $65,000 is about 88.8% call it 9% why is that well some of that 65,000 was taxed at 0% that would be the standard deduction amount some of it was then taxed at 10% some of it was taxed at 12% and then some of it was taxed at 22% so yes 22% is your marginal bracket meaning that's what you pay on the next dollar of income but the average rate was right around 9% so if you were taking $65,000 from your IRA and you're splitting that out monthly you wouldn't want to withhold at the 22% rate you would want to withhold at the 9% rate because that's the average tax rate you are paying again this is something you should talk to your financial adviser your tax prepare about to make sure that your deductions are dialed in this is just one arbitrary example but making sure you understand that difference is key to making sure that you're withholding the right way the key though to IRAs is ending that they are fully taxable at the federal level and even at many states at the state level and that's tax every dollar that you earn is tax as ordinary income still subject of course to standard deductions and things like that um but IAS are fully taxable you do have the ability with most custodians to control for how much you have withheld in taxes which is a nice benefit the next thing I want to talk about is pensions now pensions are fairly similar to IRAs for the most part pensions are going to be fully taxable now there are some exceptions to this with government pensions if you're say a disabled veteran for example you're going to have a tax-free VA benefit for that but for the most part pensions are going to be fully taxable same with IAS you're typically and this depends on the pension company able to specify the withholding on your pensions so if you're receiving $3,000 per month and you understand your average tax rate or what that should be withheld at you can simply elect with the pension company to have a certain percentage withheld for federal taxes to have a certain percentage withheld for state taxes just like IAS you'll also receive a form $199 at the end of the year that says James here was the total distributions from your pension and then here was the total withholdings at the federal level and state level if applicable I think you can probably start to see with this that one of the complexities with retirement planning when it comes to estimating taxes is most people don't just have social security or don't just have IAS or don't just have pensions so when you're looking at these it's not enough to say okay what taxes do I owe on just my P or just my IRA or just my Social Security you need to understand the entirety of the tax picture of if you have all these income sources what tax bracket will that put you in and then withhold ingly from your social security benefit or from your IRA withdrawals or from your pension benefit but pensions going back to where we are right now pensions pretty similar to IAS when it comes to how you can potentially withhold taxes to make sure that you're making that estimated tax payment correctly throughout the year next let's talk about brokerage accounts and this is defin the most challenging or confusing one to most people so when you have a brokerage account depending on what you are investing in you are most likely incurring either interest or capital gains or dividends either non-qualified or qualified dividends now these are all taxable events which is a good thing if you weren't incurring any of them it means your money is just not growing it's just sitting there but the fact that these are happening those are taxable events and so one of the really important things about brokerage accounts when it comes to understanding the the tax impact of them is understanding what the taxable event is let me give you an example you have a brokerage account with a million in it and you're taking $55,000 per month well that comes out to $60,000 per year so a lot of people think okay I'm going to owe taxes on $60,000 per year that's incorrect though that $5,000 withdrawal that $60,000 annual withdrawal that itself is not the taxable event if all that million dollars would just say in cash and you took 60,000 out none of it taxable because you already paid taxes on all that cash what is taxable the actual taxable event is the interest that's paid on that cash it's the dividends that are paid on your stock it's any long-term or short-term capital gains either you personally are realizing or that are being realized within any mutual funds or ETFs that you own so that gets a lot of people hung up of it's not the distribution that's taxable it's the realization of gains it's the receiving of income that's the taxable event now here's the hard part about the taxable event with something like an IRA the taxable event is you pull money out so if you're pulling 5,000 out per month of an IRA that is a taxable event and the brokerage firm so a Fidelity a Charles Schwab an eade whatever it is they can have taxes withheld from that and they can pay those taxes directly to the IRS or to the state uh taxation Authority these firms these brokerage firms are typically not having having taxes withheld on any interest or dividends or capital gains so these things are all happening and even if you're not taking anything out of your account there's taxable events happening there's a taxable event that's going on that you need to understand so that you can understand how much to pay and taxes so you are responsible for reporting and paying taxes on your dividends interest capital gains when you file taxes now the good news is at the end of the year that brokerage firm that custodian they're going to send you a form 99 and there's form 1099 div there's all these different kinds of form 1099s or tax forms on that form it's going to say here's how much you received in interest here's how much you received in dividends qualified and non-qualified here's any long-term gains that you realize here's any short-term gains that you realize so they're going to fully summarize everything but the hard thing is you don't receive that until January or February sometimes even later the following year as a retiree understand the IRS likes to give paid they like for you to make your tax payments as those payments are received by you so if your only taxable event in an entire year was what happened in your brokerage account and you weren't having anything withheld from that because a brokerage account the custodian they're not withholding taxes on your behalf you might get to tax time next year and say wait a minute I'm being hit with an underpayment penalty where is this coming from what might be coming from all these dividends and interests and capital gains that were happening and even if they stayed in your account because you weren't withdrawing them the taxable event had happened so this is where you do need to do an estimate of what might those gains look like what might that interest look like tie that into as I mentioned before what tax bracket might you already be in because of Ira withdrawals pensions Social Security Etc and this is where you probably need to make estimated tax payments so the IRS has a website where you can go and you can make an estimated tax payment these estimated tax payments are split into quarterly payments now they don't actually have happen every 3 months that would be a lot more convenient a lot easier to track but they're happening in April they're happening in June they're happening in September and then January of the following year that's the estimated tax payment frequency if you want to call it that for IRS estimated taxes so at the beginning of the year if you're very on top of this or maybe your financial advisor or Tax Repair is really on top of this ideally you're doing an estimate of what might the next year look like what will it look like in terms of how much I'm taking in Ira withdrawals what will it look like in terms of how Social Security myself and maybe a spouse have coming in what will it look like if there's a property sale what will it look like really starting to make some assumptions about what's going to happen this year so that you can get a sense of okay what might my tax liability be for this year my tax liability is going to be $20,000 I can make $5,000 quarterly estimated tax payment so that over the course of the year I have paid my estimated tax liability go back to what I started with at the beginning there's a couple ways to determine this one is 90% you can pay 90% of what you expect this year's tax bill to be I shouldn't say what you expect it to be the IRS won't care about what you expect it to be the IRS will care about what it actually is so if you pay 90% of this year's tax liability you qualify for that Safe Harbor payment if you don't know what this year is going to be but you instead want to say okay I'm either going to pay 100% or 110% of last year's tax liability that too counts is a safe harbor they won't penalize you with underpayment penalties because you paid the1 or 110% of what last year's tax bill was so as we start to tie this all together I do again want to emphasize that when you're making SMA tax payments don't look at Social Security and vacuum and say okay how much of this is going to be taxed and then how much my IRA is going to be taxed look at everything understand what your average tax bracket will be understand what your marginal tax bracket will be because those will help inform different parts of your tax strategy but really understanding the combined tax bracket other considerations so things like Roth conversions for example you can withhold from Roth conversion itself so we're talking about uh tax strategy a big one for a lot of people is Roth conversions let's assume you're going to do a $30,000 Roth conversion this year because you see it makes sense for your financial plan well if you're in the 10% federal tax bracket you could withhold 10% from that tax payment 30,000 is converted 27,000 actually makes it from the IRA into the Roth IRA $3,000 goes right to the IRS that's one option so you had your taxes paid via the conversion ideally in many situations you want the whole amount to be converted so if you have 30,000 converted you want the whole 30,000 to make it to your Roth IRA so the whole amount can grow taxfree then ideally in many situations you're paying with cash on hand but that does mean you need to go make an estimated tax payment you need to go to the IRS or have some other means of withholding an extra $3,000 to account for that Roth conversion so I say other considerations because there's other types of things people do in retirement so maybe you're selling a property understand what's a tax implication of that make an estimated tax payment maybe you're doing a Roth conversion maybe you're harvesting gains on your investment accounts there's all these different things and it's not quite as simple when you're retired as it is in your working years because you don't have payroll to make these decisions for you and make these estimates for you you have to do it hopefully with the help of your tax prepare financial adviser you have to do this and you can then make the payments throughout the year to make sure you avoid any underpayment penalties so as always with any of these topics there are many many many more details along this but that's a high level overview of how much do you need to pay in taxes in retirement or how do you estimate that to avoid underpayment penalties and then an overview of how do different types of income streams in retirement get taxed so once you understand that you can start to understand what that looks like for you in retirement and hopefully come up with a game plan to make sure that you're staying on track with that so that is it for today I really appreciate that question David thank you for that thank you to all of you who have submitted questions who have left reviews it really truly does help more people so I can't tell you how many wonderful messages I get of people saying hey thank you for the podcast this is really helpful information so every time you leave a review every time you share the podcast with a friend or family member or cooworker it really helps more people get the information they're looking for to create that more Secure Retirement so thank you to all of you for listening that is it for this time and I'll see you all next week once again I'm James canol founder root financial and if you're interested in seeing how we help our clients at root Financial get the most high life with their money be sure to visit us at . root Financial partners.com