If you’re anything like me, you want to spend as little time on taxes as possible. There’s nothing worse than seeing a huge chunk of our paycheck each week going to pay Federal, State, Local (maybe), Social Security, and sometimes other taxes. Yuck!
But taxes serve a purpose. It’s nice to see the poor folks in Florida, Georgia, North Carolina and other spots in Helena’s wake getting some government support. I’m glad we have FEMA (Federal Emergency Management Administration) to help. I visited Acadia National Park over the summer. The government does a nice job with parks. They’ve also paved my street, which is nice.
So while I hate to pay taxes, I understand that they are necessary.
Tax Withholding
When we start a new job, somewhere in the pile of paperwork we fill out on day-1 is a form called a W-4, also known as an Employee’s Withholding Certificate. More about the W-4 here (from Nerdwallet). Basically, the W-4 tells a little about our filing status, other income and helps decide how much of our paycheck should be withheld for taxes.
In the US, we are a pay-as-you-go system. This means that taxes are withheld along the way as we earn income. Depending on the quality of the work we’ve done in filing our W-4, we may end up getting a refund if we over-pay taxes, or writing a check if our federal and/or state withholding is less than the tax we owe. Ideally, we will have withheld exactly the right amount so that we neither owe, nor do we receive a refund.
Retirement
But what happens when we retire? We’re no longer getting a paycheck. Who withholds?
After golf a few weeks back, Doug and I were discussing Roth conversions. I”ll do a post on this shortly. Essentially, a Roth conversion is a transfer of money from a traditional retirement account to a Roth account. We pay taxes on the money we transfer today, but once the after-tax transfer amount is in the Roth, the principal amount and any gains will not be taxed in the future. This is a bet that taxes will be higher in the future than they are today. It’s an interesting strategy, but it requires us to come up with a big chunk of change to pay the taxes today.
Anyway, this discussion prompted me to start thinking about taxes.
Where’s My Withholding?
I retired 5 years ago, but my wife continued to work until earlier this year. I guess this makes me a kept-man, so that’s cool.
She received a paycheck, had money withheld for taxes, and I completed our tax forms at the end of the year, as I’ve done every year since we were married. I really didn’t think about tax changes with retirement.
But as I began my Roth research and came across the whole pay-as-you-go thing, I realized that when my wife stopped receiving a paycheck, we had stopped paying as we went. This means trouble in the form of penalties and interest.
I spent my entire life making sure I didn’t fall into the penalty and interest trap with my credit cards, I hadn’t even thought about it in relation to taxes. I’m so ashamed.
Estimated Tax
I use TurboTax to file my taxes each year. Every year it spits out a form with my estimated quarterly tax payments. I always thought this was a suggestion for those who wanted to avoid a big annual payment. Turns out I was wrong.
Sure enough, when I looked back at my forms, Turbotax calculated a small penalty for the years where I hadn’t had enough withheld and I had a large year-end payment. Doh!
Payments
Thankfully the federal government and the state of Massachusetts have made it easy to pay estimated taxes. I don’t need to write a check, find an address, and mail a payment in and hope for the best. All of this can be done online here for federal and here for Mass.
Calculating how much to pay is another story. I’m not working, My wife’s not working. My income should be zero. Why am I paying?
In our case, we’ve not yet hit the age for social security payments, so we pay our bills from either selling shares of companies or mutual funds in our taxable brokerage account, or by taking money out of our retirement accounts. It’s a little more complicated, so let’s take a quick look.
Taxable Brokerage Account
I’ve always maxed out my retirement account contributions, but I often found myself in a position where I wanted to save more, beyond the annual 401k limit. To do this, I opened a brokerage account. I would transfer money into the account and then buy stocks or mutual funds.
The money I transferred in was after-tax. It was money from my paycheck after the government had withheld taxes. I had already paid taxes on this money, so it won’t be taxed again. This money is my cost basis.
Assuming I’ve made good investment decisions, this money grows in 2 ways.
Dividend and Interest Income
My stocks and mutual funds may pay dividends and my CDs, brokerage cash account, and bonds pay interest. Whether I reinvest this money in new shares or not, these are new earnings generated from my investments and I’ll owe tax on these. This info will be reported annually from my broker on a 1099-DIV, or 1099-INT, and I’ll include them on my tax form.
Capital Gains
My money may also grow from capital appreciation. If I buy a single share of a company for for $100 per share, and after a year, the share price increases to $110, I’ve made $10 on my investment of $100. The $100 is my cost basis. This is what I bought the share at using money that had already been taxed. The $10 is new earnings on that $100 investment and the government is itching to get its share. That $10 will be taxed, but only when the gain is realized.
Realized v. Unrealized
Apple stock is down today. It was up yesterday. At any given time, there are unrealized capital gains and losses in an investment. If I buy a share of Apple stock at 10am for $100 per share and it immediately goes up to $105 per share, do I immediately pay taxes on the $5 gain? At the end of the day, it has dropped to $95. Do I file my taxes again and get a refund?
No, that’s crazy talk. We don’t tax unrealized gains. Gains are not realized until the asset is sold. Whether that asset is a stock, bond, mutual fund share, home, vintage car…..values fluctuate constantly. It is only when the asset is sold that we calculate the realized gain – the difference between the price paid and the price received, that we realize the gain and are responsible for reporting the gain and paying taxes on those gains in that calendar year.
Note: This is a hot topic for me as there are “Tax the Rich” schemes floating around that advocate for a tax based on unrealized gains. Since the rich guy’s wealth is tied up in assets, the proposal is to tax the unrealized asset values. This is a slippery slope. Stay tuned for a future post.
Income
So, my taxable brokerage account is creating income for me. I’m getting dividends and interest as I always have. But now that I’m retired, I’ve been selling some shares of assets I bought 20 or so years ago and using the money to pay for our spending. I’ll get a 1099-B for the realized gain, along with the 1099DIV, and 1099-INT that I’m used to getting.
But, no money has been withheld on this income. I’ll get the 1099 forms before I file my taxes, but at that time it will be too late to pay estimated taxes. I need to estimate my earnings and the tax rate on those earnings in order to decide what my quarterly federal and state payments should be.
Calculating Estimated Payment Amounts
It’s easier than you may think.
I no longer receive a paycheck, so how much cash do I need to fund my monthly budget. If you don’t have a budget, read the post on budgets here.
Based on our spending needs, we need to make a plan for how much of that spending will be covered by dividend and interest payments and how much will be covered by selling assets.
We may also tap into retirement accounts, but hold that thought for now.
To get an estimate of my investment income, I’ll look at the monthly dividends and interest produced by my taxable accounts. This includes my bank accounts, CDs, High Yield Savings Accounts and Taxable Brokerage Accounts. Then I’ll decide which taxable assets I’ll sell to raise cash. My broker nicely displays the cost basis, the current value and the gain/loss. I’ve already paid tax on the cost basis so I’ll only be taxed on the gain (if any).
Add these 2 together and that’s my expected investment income.
Assuming I’m not collecting rent, receiving alimony, or getting any other type of income, this is what I’ll be taxed on.
Federal Tax
See here for the IRS tax brackets and description for how 2023 taxes are calculated. We’ll need to estimate taxes owed to come up with a quarterly payment.
Before we start the math, we need to account for our standard deduction. In my case, I am married filing jointly, so I subtract about $24k from my income for the standard deduction. I’ll pay taxes on the remaining amount.
The US has a graduated tax system. Read here from Nerdwallet for a description of how this works.
We can take our total expected income minus our deduction, and then apply it to the tiered tax table to get an idea of how much we’ll owe. Divide this amount by 4 and start making quarterly payments.
State Tax
State is even easier for me. In Mass, we pay a flat 5% income tax. I take out or $8,800 deduction for joint filing and then apply the 5% rate to the remaining amount. I divide by 4 and make a quarterly payment.
Retirement Accounts
I have decided not to take money from retirement accounts just yet. Instead, I’m using dividends, interest and asset sales from our taxable brokerage account. The main reason that I’m not taking retirement assets is that I’m considering a Roth conversion of retirement assets. More on this in an upcoming post.
But for many, now is the time to take retirement money, assuming we’ve reached the age of 59 1/2. There are several variations for 401k and Roth which we won’t try to cover here, but in general, 59 1/2 is the age where we can start accessing retirement funds without paying a penalty.
We’re too young for required minimum distributions, which start at age 72, but we’re free to take funds penalty free once we pass age 59 1/2.
Traditional Retirement Accounts
If we’re taking from a traditional IRA or 401k, (or 403b, or a few others…) we will be responsible for paying taxes at ordinary income rates for the full distribution amount. As you may remember, this money went in tax free. Once in, it is tax deferred, which means it can grow within the account, but once we take it out, we’ll pay taxes on the entire distribution.
At the end of the year, we’ll get a 1099-R from our broker to help us file our taxes, but we’ll need to estimate the amount we plan on taking so that we can pay estimated taxes.
Roth Retirement Accounts
If we have a Roth retirement account, we have already paid taxes on the money when it went in. So that means that the principal, as well as any earnings, are now tax free. Roth money needs to be in the account for 5 years before we can take it out, but once we’ve reached 59 1/2 and the money has been there for 5 years, we pay no additional taxes.
We can exclude Roth money from our estimated tax calculation.
Wrap-Up
I was caught off-guard on estimated taxes. I was so used to our employers handling tax withholding for us, that I was not prepared for paying estimated tax in retirement.
The US has a pay-as-you-go system, which means we may pay penalties and interest if we do not submit tax payments to federal and state taxing authorities as we earn money. While we may no longer be earning a salary from an employer, we are likely liable to pay taxes on dividends, interests, realized capital gains, and traditional retirement distributions.
It’s not that hard, but we’ll need to estimate our annual income from these sources and submit quarterly estimated tax payments to both federal and state taxing authorities.
And don’t worry about over or under paying. At the end of the year, we’ll file our tax returns and if we’ve over-paid, we’ll receive a refund. If we’ve under-paid, we will owe money. If we’ve significantly under-paid, we may receive a penalty, but we’ll know better for next year.