How Much in Taxes Should I Withhold from my Pension?

Estimating tax withholding on pension income

Woman doing taxes
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When you start a pension, you can choose to have federal and state taxes withheld from your monthly pension checks. The goal is to withhold enough taxes that you won't owe much money when you file your tax return. You don't want to get a large refund, either, unless you like lending money to Uncle Sam.

If you choose not to have any taxes withheld, and you underpay your taxes, you could end up owing taxes plus an underpayment penalty.

To avoid this, you'll want to estimate your income for the year, and set your tax withholding appropriately.

How Much in Taxes Should You Withhold?

If you are newly retired, it can be difficult to figure out how much in taxes to withhold from your pension as your tax rate depends on your household sources of income and deductions. 

When you add up all your sources of income and subtract out your deductions, you get your taxable income. Your taxable income determines your tax bracket, and you can use this tax bracket to estimate how much to withhold. When you look at a chart of tax rates you can see that higher amounts of income will be taxed at higher rates.

Tax planning can help you figure out the right amount to withhold. With tax planning, you put together a "pretend" tax return, called a tax projection. As you transition into retirement, you might want to work with a CPA, tax professional, or retirement planner to help you with this.

If you prefer to do it yourself, you can plug numbers into an online 1040 tax calculator to get a rough estimate. Or you can fill out your federal tax form as if you were filing taxes. Follow the instructions to see where each source of income goes. Calculate the tax you think you will owe. Divide that by your total income.

Use the answer to see what percentage to withhold.

For example, let's say your total income will be $20,000 from a pension and $30,000 that you will withdraw from your IRA. You fill out a pretend tax return and calculate you will owe $5,000 in taxes. That is a 10% rate. You can have 10% in federal taxes withheld directly from your pension and IRA distribution so that you would receive a net $18,000 from your pension and $27,000 from your IRA.

When to Change How Much Tax is Withheld from Your Pension

When you are working, you can change the amount of tax withheld from your paycheck each year. In retirement, you can do this too. When your tax situation changes, you will want to adjust your tax withholding.

For example, your first year of retirement you may have a salary part of the year, and you may have a spouse who is still working. This means you may need to withhold a larger amount of taxes from your pension for that year. In subsequent years, your income may change, which means you should adjust your tax withholding.

The following events may trigger a need to change your tax withholding in retirement:

  • Spouse stops working
  • You or a spouse take on part-time work
  • You pay off a mortgage or take on a mortgage
  • You have a large amount of taxable capital gains from the sale of a property, mutual funds, or stock
  • You take withdrawals from an IRA or 401(k) account
  • You or a spouse start Social Security benefits
  • You reach age 70 and required IRA distributions begin

Change in Withholding When You Start Social Security

Many retirees who have a pension are surprised by the increase in their taxes when they start Social Security. The amount of your Social Security benefits subject to taxation depends on your other sources of income. If your pension started a few years ago and now you are starting Social Security benefits, you will likely need to increase your tax withholding.

Change in Withholding When You Reach Age 70

When you reach age 70 ½, you are required to start taking distributions from traditional IRA accounts and other qualified retirement plans like a 401(k).

These distributions are included as taxable income on your tax return. Most of the time you will want to have taxes withheld from these IRA/401(k) distributions.

Some people take an IRA distribution or cash-out an old 401(k) plan early in the year and forget about it by the time they file their tax return. They are surprised by the amount of taxes they owe. Don't let this happen to you. Whenever you withdraw money from any accounts in retirement ask about the tax implications. It is better to plan ahead than to get behind on taxes.