During our working lives, we become accustomed to the rhythm of a bi-weekly or monthly paycheck. For most of us, that is 40+ years of paying bills, saving for retirement, and handling other expenses from income that regularly flows into our bank accounts. What happens when you finally retire and the paychecks suddenly stop?
This is a question we often hear at Briaud Financial Advisors from clients as they approach retirement.
How do I get my money in retirement?
Let’s revisit Mary and Cal in our recent post about Social Security. Mary recently retired from her job as a professor of chemical engineering. She and Cal are now both age 70, and have decided to file for their Social Security benefit; their combined Social Security income is expected to be $73,740. Through Mary’s time as a professor, she is now eligible for a nice pension of about $30,000/year from the University, but that won’t cover their spending of $200,000 per year (including taxes). To cover the extra $96,260, Mary and Cal have also saved money into IRAs, Roth IRAs, and a brokerage account, so they have plenty to cover this spending.
Most retirees have concerns about the mechanics of how you get paid in retirement: When do you receive money, and how do you access the money you need to support your lifestyle? Below are four ways which we typically handle withdrawals for our clients:
- Linking your investment portfolio to your bank account. You can establish a link between your IRA/Roth IRA/Joint/Individual account and your bank account. Then, when you need money, you transfer what you need.
- Bill Pay/Checkbook. You can set up bill pay on your account and get a checkbook, so you spend only what you need from your accounts. You can also have expenses directly deducted from your accounts, although you have to be careful when doing this.
- Regular paycheck. You can establish regular withdrawals that get deposited into your bank account at whatever interval is comfortable to you, mirroring the same process of receiving a “paycheck” every two weeks.
- Lump-sum. You can take a lump sum into your bank account at the beginning of the year and live on that or have larger chunks come out at whatever interval is comfortable for you.
Your preference essentially informs the mechanics, and you can use any combination of these options to get paid in retirement. Optimizing your tax situation in retirement is the other half of the story. We work with our clients to maximize the most efficient way to draw from these accounts over the course of their retirements to minimize the tax burden.
How do I pay taxes in retirement?
We talked about how you get paid in retirement, and now we focus on how you pay taxes in retirement. For most taxpayers, their tax liability has been taken care of by the federal and state withholding on each paycheck. For many years, tax withholding decisions are on autopilot, and no adjustments are needed.
When transitioning into retirement that autopilot goes away, and taxpayers need to make decisions actively so they do not have a surprise tax bill at tax-filing time.
There are three primary ways in which retirees pay their taxes.
Withholding from Social Security and or pension
Individuals who are taking Social Security can request the Social Security Administration to withhold federal taxes from their benefits. However, you are limited to the amount that can be withheld. Taxpayers can withhold 7%, 10%, 12%, or 22% from their benefit. The withholding election is different from other payment options in which you can select a specific amount.
To have withholding taken from your Social Security check, you need to complete a W-4V form and mail it to your local Social Security Administration office. The form can be found here.
Withholding from retirement distributions
Retirees with retirement accounts — such as 403(b)s, 401(k)s, IRAs — can have taxes withheld from their distributions. Two of the most significant benefits of using all or a portion of your retirement distribution for taxes are:
- You can withhold a specific amount from the distribution. A nice benefit if you are trying to pay in a certain amount.
- Payments made from an IRA can avoid a late payment penalty related to paying taxes (see estimated tax payments below).
When requesting your distribution, you can notify your custodian of the amount of taxes (percentage or fixed amount) you wish to withhold. The custodian(for example Schwab, TIAA) will directly send the payment to the government and include this payment on your year-end tax statement (1099-R).
Estimated tax payments
The third, and to be blunt, the least popular choice among our clients, is making estimated payments. The payment, usually based on your projected tax liability, is typically made in 4 equal installments, which are due on or around April 15, June 15, September 15 and January 15 of the following year.
Traditionally taxpayers have written out checks and included a form 1040-ES prepared by their CPA.
Many individuals find using the IRS Direct Pay website to be much quicker and easier to track the payments.
If you decide to make estimated tax payments, read our blog post about avoiding paying tax penalties.
The mechanics of paying taxes – a case study
Mary and Cal, working with their advisor and CPA, know they will pay taxes on their income. According to the tax analysis, they will owe $12,650.
Below are a couple of ways to cover their tax liability:
If they withhold from Social Security and or a pension
Their annual Social Security Income is $73,740. They could both elect to have 22% from their Social Security payment for total payments of $16,222 and receive a refund.
If they withhold from retirement distributions
Cal, who took a withdrawal from his IRA, can instruct his custodian (for example, Schwab, Vanguard) to withhold $12,650 of a $15,000 distribution and receive a net payment of $2,350. The remaining $12,650 is used to pay their tax liability.
If they make estimated tax payments
The last option they could consider is making an estimated payment of $3,163 on or before April 15, June 15, September 15, and January 15.
Working with you and your CPA, we can create a customized plan for you to ensure there are no surprises come April 15.
Transitioning into retirement is stressful, but you can enjoy the peace of mind that comes with knowing your tax payments and withdrawals from your portfolio can quickly be taken care of.
If you would like help deciding how much you can take from your portfolio and how to reduce taxes while in retirement, reach out to us.
Post written by John Bohnsack, CFP®. He joined our team in 2011 and earned his CERTIFIED FINANCIAL PLANNERTM certification in 2012. Learn more about John here.