Anyone who does their own taxes has been there before. The moment you input all of your taxes, hit the submit button, and close your eyes and hope that you don’t owe money. Taxes are pretty simple. Have enough withheld throughout the year and you won’t owe any during tax time, and may even get a refund. Don’t have enough taxes withheld, and you may be faced with writing a check to the government each April.
You may have though the Trump tax breaks would reduce taxes, which would result in a nice tax refund. However, many people are waking up to the reality that not only are they not getting that tax refund, but they are also actually having to pay additional taxes. No one wants to get out the checkbook during tax season. This article discusses ways in which you can increase your tax withholding so that you aren’t writing a check next tax season.
Taxable income in retirement
There are typically four sources of income in retirement. You may have income from all or only one or two of these sources. Here are the primary sources of income that you will have in retirement, and the standard tax withholding on each type of income.
| Type of Income | Federal Withholding | Michigan State Withholding |
| Social Security | 0% | N/A |
| 401(k)/403(b) Withdrawals | 20% | 4.25% |
| IRA Withdrawals | Flexible | Flexible |
| Monthly Pension | Estimated Withholding | Estimated Withholding |
If you are interested in a more comprehensive view on taxation in retirement in Michigan read the article, “Michigan Taxes in Retirement”. Next, we will look at each source and how to change the tax withholding.
Social Security
Federal taxes: First, it is important to understand how much, if any, of your social security, is taxable. You can easily see this on your 1040 tax form. On the new 1040 form, line 5 you will see two numbers if you are collecting social security. 5a is the amount of social security benefit you collected. The second number, 5b, is the amount that is included in income and taxable to you. The most that is included as income and taxable is 85%. The higher your income, the more of your benefit is taxable to you.
When you start collecting social security, typically no money is withheld to pay federal taxes. If you have a significant amount of income from social security and have no tax withholding, you may end up paying taxes at tax time. If this is the case, consider having some taxes withheld from your social security benefit. In order to have federal taxes withheld from social security, you will need to complete IRS Form W-4V. You will have the option to have 7%, 10%, 12%, or 22% withheld to pay federal taxes. Form W-4V can be mailed back or brought into a local social security office.
Michigan state taxes: Good news, there are no Michigan state taxes due on social security. Therefore, you can’t and shouldn’t need to have any taxes withheld from social security to pay Michigan state taxes.
401(k)/403(b) Withdrawals
Federal taxes: There is a mandatory 20% withheld from 401(k) distributions to pay federal taxes. This only applies to a 401(k), not an IRA. A benefit of an IRA over a 401(k) is that you have more flexibility on tax withholding. For information on IRA withholdings, see below. There is a mandatory 20% withholding on a 401(k) distribution, however, you can typically have more withheld. Contact your 401(k) company to have an additional specific dollar amount withheld on your 401(k) withdrawal.
Michigan state taxes: The Michigan state tax rate is 4.25%. However, if you were born before 1952, some or all of your retirement income may be free from Michigan state taxes. If you were born after 1952, your full retirement account withdrawal is subject to Michigan state taxes. If that is the case, you will want to make sure the full 4.25% of your distribution will be withheld to pay Michigan state taxes. When you take a withdrawal from the 401(k) you should be informed how much will be withheld to pay state taxes. If 4.25% is not withheld to pay state taxes, you will probably want to add more to make sure the full 4.25% is withheld.
Individual Retirement Account (IRA)
Federal taxes: As I mentioned above, the IRA is the most flexible account for tax withholding. You can have as little as 0% and up to 100% withheld to pay federal taxes. The benefit of this approach is that you can have the exact amount withheld so that you aren’t overpaying throughout the year and you aren’t having to pay at tax time. Many of us don’t pay 20% on taxes in retirement. However, 401(k) distributions require that you have 20% withheld to pay taxes. This means that larger distributions are required from a 401(k) to get the same amount as what you may get from an IRA.
For example, let’s say that you want $5,000 after-taxes and you only have an effective tax rate of 10%. If you were to take the withdrawal from a 401(k), with mandatory 20% withholding, you would need to take out $6,250 to get your $5,000 after taxes. In an IRA you can have exactly 10% withheld, which means only a $5,555 withdrawal is required. Now, if you take the withdrawal from the 401(k) and pay the 20% withholding, you will get a larger refund at tax time. However, that money is now officially out of the 401(k) and can’t grow tax-deferred any longer.
Michigan state taxes: Like federal taxes, you are also free to select how much you want to have withheld for state taxes. You can have no tax withholding if you want from state taxes. However, as noted above, you will typically pay 4.25% in Michigan state taxes on IRA distributions. If you would like to have 0% withheld for Michigan state taxes, Michigan requires that you sign off on having nothing withheld. Sending in Michigan Form WP4 to your IRA custodian allows you to have 0% tax withholding.
Monthly Pension
Federal taxes: First, it is important to know how much is being withheld from your monthly pension to pay federal taxes. You want to divide both your federal and state taxes by your pre-tax pension benefit. This will tell you how much is currently being withheld on a percentage basis and can help you decide if more is required to be withheld. I have seen pension companies withhold money in two different ways; a flat 20% of the pre-tax amount and also an estimated amount based on the size of your pension benefit. If the pension company is withholding an estimated amount, many times I see that they underestimate how much should be withheld. This is because the company doesn’t know other sources of income, like social security and retirement account withdrawals. You are typically allowed to have an additional amount withheld by simply calling the pension administrators if necessary.
Michigan state taxes: As mentioned above, your Michigan state taxes are typically 4.25% on all retirement income if you were born after 1952. You want to make sure that your pension administrator is withholding this 4.25%. If not, you should be able to call in order to have additional state tax withheld.
In Conclusion
I recently spoke with a person that was potentially going to have penalties on his taxes for not having enough withheld throughout the year. Typically, if you don’t have at least 90% of your tax liability withheld throughout the year, you are in danger of having an underpayment tax penalty. Your solution to having an underpayment penalty is to make quarterly payments or to have more withheld to pay taxes throughout the year. I don’t know anyone who wants to make quarterly payments to the IRS. Increase your tax withholding and avoid having to write the IRS a big check at tax time and the potential penalties.
Need Additional Help?
Are you interested in working with a financial planner to help you maximize your income and reduce taxes? If so, consider working with a fee-only financial advisor that truly looks out for your best interest. RetireMitten Financial was created to provide the best advice, with no conflicts of interest. Schedule a complimentary meeting below so that we can discuss your situation and how we may be able to help.
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