Money

Do I Need To Pay Estimated Quarterly Taxes In Retirement?

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The U.S. tax system is a pay as you go system. You must pay taxes on your income throughout the year. Failure to do so can result in the IRS imposing penalties on you.

When you are working as an employee, your employer withholds taxes based on information you provide to them on Form W-4. This typically fulfills the pay as you go requirement.

When you retire, you may derive income from any combination of investments, Social Security, a business, consulting, or part-time work. As such, you may need to pay estimated quarterly taxes.

Do you understand who needs to pay quarterly estimated taxes, how to determine how much you owe, how and when to pay, and penalties for failure to meet these requirements?

What is Estimated Tax?

You pay estimated tax on any income that isn’t subject to withholding. This includes:

  • Self-employment income
  • Dividends and Interest
  • Rent
  • Taxable alimony payments
  • Other taxable income including retirement account distributions and Social Security when voluntary withholding was not elected.

Who Needs To Pay Quarterly Estimated Taxes?

You generally need to pay estimated taxes if:

  1. You expect to owe at least $1,000 at the end of the year after subtracting any withholding and refundable tax credits, AND
  2. Your withholding and refundable tax credits are expected to be less than the smaller of:
    1. 90% of the tax shown on your current year’s return, OR
    2. 100% of the total tax owed on your prior year’s return (110% if your AGI is >$150,000 and you file married filing jointly).

If you derive most of your income from self-employment, you most likely will have to pay quarterly estimated taxes.

If your retirement income comes from investments, Social Security, or part-time work performed as an employee, you have the option to pay estimated taxes. You also have the option of withholding income from these sources.

Tax Withholding

The IRS provides a tax withholding estimator to help determine the appropriate amount of tax to withhold. 

For retirees getting most of their income from investments, you can have taxes withheld from distributions. This is typically the default setting at brokerages for retirement accounts. For example, Vanguard withholds 10% of distributions from traditional, SEP, and Simple IRAs. 

You have to manually opt out of withholding if you prefer to pay estimated taxes. You do this by completing IRS Form W-4P

This may be preferable when performing Roth IRA conversions and wanting the full amount to be rolled into the Roth account. This assumes you have money from other sources that can be used to pay the required taxes on the distribution.

If distributions are made outside of the United States, the 10% withholding is mandatory. You may not opt out.

Social Security does not withhold any portion of your benefits by default. If you want to withhold money from your Social Security benefits, you have to elect to do so with IRS Form W-4V.

If you work a W2 job, you can increase the amount your employer withholds to avoid paying estimated quarterly taxes. You do this by completing IRS Form W-4 and giving it to your employer, who will withhold the tax for you.

How Do You Estimate Taxes?

Find instructions for estimating taxes on IRS Form 1040-ES. This includes an estimated tax worksheet. If you haven’t had to pay estimated taxes and/or your situation is expected to be different than it was in the past, this worksheet is very helpful.

Since our household has been paying estimated taxes and we don’t expect our situation to change much this year, we simply use our past year’s taxes as a guide. We pay estimated taxes plus withholding from my wife’s job equal to 100% of last year’s taxes.

This satisfies the requirement of paying 100% of the total tax owed on our prior year’s return. However, if your situation is changing substantially, this may cause you to substantially over or under pay your taxes, leaving you with a larger tax bill or refund than you may desire at the end of the year.

When and How Do You Pay Quarterly Estimated Taxes?

As with most things IRS related, this is not simple and straightforward. The term quarterly taxes is somewhat of a misnomer, as they are not actually due every three months. 

Assuming you pay taxes based on a calendar year, estimated quarterly taxes are due the 15th (or the first business day after if the 15th falls on a weekend or holiday) of April, June, and September of that year, with the 4th payment due in January of the following year.

The IRS expects to be paid. Thus, they do make paying the taxes easy.

You find tax vouchers on Form 1040-ES which can be mailed in with a payment. You also can pay online by credit card for a small fee, which I personally choose if it helps me to meet credit card sign-up bonuses that far outweigh the fee.

Are There Penalties for Failure to Pay Quarterly Estimated Taxes?

The IRS’s pay as you go system helps to insure that people aren’t surprised by a large tax bill at the end of the year that they may not be able to pay. People reading this blog tend to have substantial savings and may prefer to just pay once a year. But is that wise?

In a word. No.

Penalties and interest are charged for failure to pay estimated quarterly taxes on time. There are means to appeal penalties for late or non-payment due to “reasonable cause.”

However, as with all tax topics, it is best to learn the rules and play within them. No one enjoys paying taxes, but it beats dealing with the consequences of not paying what you owe!

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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at chris@caniretireyet.com.]

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