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3 ways to prevent a surprising tax hit when you retire (especially for teachers)


Paying taxes is something we all have to do, and the more we pay, the more we might resent that fact. Every year, we file our tax returns and hope that we’ve paid enough.

But when you stop working and retire, taxes don’t necessarily go away. Additionally, if you have multiple sources of retirement income (pension, IRA, Social Security), you have to keep track on how much tax you’re withholding on each and ensure that it’s going to be enough to cover your whole liability come the end of the year.

 

And herein is where the problem lies.

 

While working, you’ve filled out a W-4 with your employer to make sure you have enough tax withheld. If you have one source of income, you can adjust this year-on-year to ensure its accurate and be close to the amount you actually owe.

But in retirement, you’re on your own.

Typically, pensions will withhold a small amount, if any. IRAs will suggest an amount – and may have a mandatory minimum – but might not be accurate for your situation. If you’re not careful, you may get to the end of the year and owe thousands in taxes by not managing and reviewing your withholding throughout the year.

This problem is common when people retire in the middle of the year – like teachers. The W-4 for employment covered the first six months of taxes, but without careful planning, the last six months of the year (when a pension is being paid) can be under-withheld, leading to a large balance being owed.

 

How do you prevent this problem?

There are three ways to prevent this problem from occurring:

1. Work proactively with a CPA / accountant

If you are not working with an accountant throughout the year by the time you retire, it’s now time to find one. You don’t need a tax preparer to look back on the year and see where you went wrong, you need someone to work with you to look forward to the next year and see what tax situations need planning for.

Explain to them that you’ll be retiring mid-year (if you’re a teacher), and need guidance on how much to withhold from your pension. If you’re retiring at the end of the year, explain to them that you need to review your income sources for the upcoming year, and design a withholding plan that will not leave you owing a large balance at the end.

 

2. Be aware that the more taxable income you generate, the more you’ll need to withhold

The United States has a progressive tax system. This is a fancy way of saying “your income will be taxed through various tax brackets, with the higher part of your income being taxed at a higher rate.”

But it has it’s quirks: if you have a pension of $150,000 versus $50,000, the tax bill is not going to be three times as much. But if you only withhold 10% on the entire amount (which might have been enough for a $50,000 pension), you’re going to be under-withheld by the end of the year.

The more taxable income you generate in retirement, the higher percentage amount you’ll need to withhold across that entire amount to meet your overall tax liability.

3. Design a plan ahead of time

When I work with clients, taxes are something that we talk about a lot – while they’re working, as they transition into retirement, and throughout retirement.

The easy way to avoid a problem is to see it coming and prepare for it. I design retirement income plans for my clients so we can see where higher amounts of income might be coming in, and they need to withhold more taxes. Or we might find a year when income changes – like teachers transitioning from paychecks to a pension – and we need to be vigilant about checking withholding rates and doing frequent tax projections. Doing this, while working closely with a CPA to verify everything is correct, is something my clients really appreciate. But you could also do it yourself, and still stay on top of things.

 

Taxes don’t disappear when we retire – in fact, they can be more difficult to manage if you have multiple sources of income. Be sure you’re working with professionals who can help you track this and look forward to prevent any problems sneaking up on you. Retirement is meant to be enjoyed, not spent worrying about taxes!