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How the Tax Changes Affect Retirees' Bills

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With the new tax laws going into effect for 2018, many retirees are wondering how that might affect their tax bills. Joining me to discuss that topic is Tim Steffen. He is director of advanced planning for Baird Private Wealth Management.

Tim, thank you so much for being here.

Tim Steffen: Thanks, Christine.

Benz: The topic I'd like to cover today is retiree taxes. There is a lot that's changing starting in 2018. First, let's discuss an overarching principle for thinking about tax payments throughout the year. How should investors approach that question?

Steffen: The general theme we try to encourage with investors and taxpayers is, when you are figuring out how much to pay during the course of the year, you want to pay just enough tax during the year to avoid getting hit with an underpayment penalty. You don't want the IRS will penalize you for paying too little. But you don't want to pay all your taxes upfront. You want to maintain the use of that cash for as long as you can. You pay just enough to avoid the penalty and then plan to have a balance due when you file your tax return in April.

A lot of people don't like to do that. They don't like writing their check at the end of the year. They prefer to get the refund. But you're making an interest-free loan to the government when you do that. I think when people think of it that way, they think, I'd rather maintain the use of my money. So, in general, you want to pay as little as you have to during the year and then write the check in April.

Benz: One of the ways that taxpayers try to figure out, well, how much will I owe for a given year is to look back to the previous year. We have a big change in terms of the tax laws starting in 2018. What are the perils of using your 2017 return, what you paid in 2017, to determine how much you should be paying throughout 2018?

Steffen: As you said, one of the ways that people look at how much do I have to pay and to avoid that penalty, what's that target I have to hit, there's a couple of different things that you can look at. One is paying in off of last year's tax liability and one is paying off of current year tax liability. The easy thing is to pay off what you paid last year. For most people, that's 100% of your prior year tax liability and that's not the balance due in April. That's the total taxes you paid during the year. Either 100% of that--some people with higher income obviously have to shoot at 110%--but at least that's a fix number. So, it's really easy. You know what the number is. You just take that number, divide it by four, and you make payments during the course of the year or something like that.

The problem with that this year is, we've got this tax reform hanging out there. And there's a lot of changes happening in 2018. While not everybody is going to see lower tax liabilities in 2018, the studies are showing that the vast majority of people will, upward of maybe 80% of taxpayers, will pay less in 2018 than they did in 2017, all things being equal. For those taxpayers who are going to see a fall in their tax liability this year, paying payments during the course of this year based off of last year's liability may not be very appropriate. It may not be the best use of your cash during the year.

Benz: You might end up with a refund which, as you talked about at the outset, that's not an optimal use of your funds.

Steffen: You'd like getting the check, but it's really not the best use of your funds to give the IRS the check earlier.

Benz: In terms of the logistics of paying those taxes, if you are retired you can either take withholding from your IRA distributions, from your Social Security payments, or you can pay quarterly throughout the year. How do you come down on that question for retirees?

Steffen: Once you have figured out what your target is for the year, how much you have to have paid in by the end of the year, you're right, you've got a few options. You can either have that withheld from certain income payments that you get during the year or you can make estimated payments. Not all income from a retiree is subject to withholding. Social Security benefits, you can have taxes withheld on. You can have your advisor withhold on IRA payments or a pension payment you might get from an employer or maybe even deferred comp payments. But things like investment income typically isn't subject to withholding--capital gains, dividends, interest, that kind of thing. Or if you've got some income coming from a rental property or business, like that, you are not going to have withholding on that either.

In those cases, you'd either have to have to more withholding taken from the other income or supplement that withholding with estimated payments. You've got to decide which one is easier, more convenient for you. There's pros and cons to both of those. The withholding is really easy because you tell somebody else, take this amount out of my check, I don't even want to see it. By the time you get it, it's net of withholding, you don't have to worry about paying the taxes. But you are paying that throughout the course of the year, and you are not getting to keep that money for as long as you possible could.

Benz: You are kind of prepaying. If you take your distribution at the beginning of the year, you are taking the whole tax out straightaway?

Steffen: Exactly. For those who take an RMD, for example, right in January, they are paying all that tax upfront. If you wait till December, you are paying it right at the end of the year which may be better, you get to use your cash a little longer, keep it invested, but then you also have to pay some tax during the course of the year, too, especially for those items that are not withheld on. That's where we get into the idea of estimated payments.

While withholding is easy, estimated payments actually give you a better use of your funds in many cases. If you've got large investment income, rental property income, or something like that, you may have to make a quarterly payment during the year. That gets you to keep the use of your cash a little longer, but you also have to remember to make the payment. If you forget, you can always pay it late, but IRS is going to charge you interest from that due date going forward.

Benz: Put it on your calendar. Let's talk about retirees who for one reason or another end up with some big infusion of cash into their retirement plan and kind of managing the taxes around those big payouts. How should they approach that?

Steffen: As we said before, you can pay your taxes based off of your prior year tax liability. Let's say you are a retiree who is plugging along and maybe you are in your 60s or so and you come up on RMD age and all of a sudden, your income jumps up because now you have to take these required minimum distributions. The question is, do you pay the taxes on those RMDs right away or can you wait to pay those the next year? And again, if you are paying off of prior year taxes and you have a spike in income, you can wait to pay the taxes on that spike until you file your tax return.

Same thing goes for retirees who maybe realize a big capital gain from the sales of some stock or a property or something like that. Yes, the gain is taxable, but you don't necessarily have to pay the taxes on that right away. You can wait until you file your tax return. As long as you hit that prior year tax liability target, that 100% of prior year, you will be OK in terms of avoiding a penalty.

Benz: That might result in me underpaying, but the benefit is that I would just pay later on as opposed to paying right off the bat?

Steffen: You might not even be underpaid in terms of penalty calculations. As long as you've got withholding or something else through your other payments that hits that 100% target of last year, this year you can wait to pay that extra tax when you file your return. Now, that may flip itself in that third year when your income comes back down to a normal level. You don't want to pay in based off of that high-income year. Then you've got to be more careful about how your payments are done. Then you've got this other target you can shoot for, which is 90% of your current year liability. In the down year, you had the big income spike one year, the next year income is more level, now you are hitting 90% of that target liability each year. You've got to be a little more careful of that because it requires a more exact calculation.

Benz: Let's talk briefly about RMDs, required minimum distributions. Obviously, a huge topic, but how can I think about managing my tax burden relative to my RMDs?

Steffen: Some people take their RMDs at the beginning of the year and you can have withholding taken out there. That may be a bit of an early prepayment of your taxes. You don't necessarily have to do that. Other people will let the RMDs wait until the end of the year. Leave it in the retirement account as long as possible, get as much tax-deferred growth as you can. Then you take it out in, say, November or December and you have taxes withheld from there. The fear from there that some folks might have is that, well, if I don't pay my taxes till the end of the year am I going to get penalized for being underpaid at the beginning of the year. One of the quirks in this whole penalty calculation thing is that withholding is automatically considered paid evenly throughout the year. Even if you pay it at the very end of the year. So, if you wait to have an RMD in December and you have it all withheld on, then the IRS won't care that it happened in December. They will treat it as if it happened evenly throughout the year. That can be a way for somebody who is maybe behind on their tax payments a little bit, take a little extra out of the IRA, have it withheld on. The IRS doesn't really care when you take it. They treat it as if it came throughout the year. It's a way to catch up for those who may be fall behind a little bit.

Benz: All of this suggests to me that one should get some help in these matters rather than just trying to go it alone, although you may get help from some tax prep software.

Steffen: Certainly, in the first few years as you are dealing with this, once you get into this, retirees tend to get into a routine. Income tends to be pretty consistent from year to year. You kind of get a handle of what your liability is going to be and how much to pay in. Unless you get something like this year where …

Benz: Big changes.

Steffen: … Yeah, your income may stay the same, but your taxes might fall. If you are paying in off of last year's income, you may find yourself, again, overpaid as we said before.

Benz: Last thing, Tim, is how state taxes fit into all of this? We've been talking about federal taxes, but what are the differences with state taxes?

Steffen: The first thing is, not all states have these big radical changes like we've seen on the federal side. While federal tax liabilities may be down, state tax liabilities, they might actually be up in some cases, because while states have lost some of the deductions that we claim on the federal side, they haven't lowered their tax rates in response to that. It's possible you might owe more on the state side.

The second thing is, they have their own rules in terms of what you have to pay to avoid a penalty. There's a lot of correlation between them and the federal rules. They are pretty similar, but not always. The withholding options for state taxes aren't always the same as they are for federal taxes. A lot of IRA custodians or Social Security benefits for that matter, they can withhold federal taxes, but state tax withholding maybe a little trickier. You want to make sure you've got that state tax covered, if not through withholding then through estimated payments.

Benz: Tim, always great to hear your insights. Thanks so much for being here.

Steffen: Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.