Adjusting withholding can sometimes produce a surprise.
While preparing a client’s tax return the other day, the result was that he had nearly a $5,000 refund coming. Often when we have a large refund coming we think “Nice! It’s like an unexpected gift!” But as you’ll see below, this is not a gift – it’s actually costing quite a lot in taxes in this particular case.
Naturally, as in most cases like this, I reviewed his income sources and withholding to see if there was anything obvious that we could change for him that would make his withholding more efficient.
| You see, it’s most efficient to have no refund at all from the IRS when your taxes are prepared. In fact, owing an amount up to just south of $1,000 is the most efficient outcome. This is because you’re getting the use of that grand of income tax throughout the year with no cost. In other words, through the year the IRS has loaned you nearly $1,000 and charged no interest.
The $1,000 amount is important here – because if you have more than $1,000 owed in taxes two or more years in a row, the IRS begins to get annoyed about it. As a result, they assess a penalty for underpayment of tax when you owe too much year after year. But if you keep the amount owed down to $1,000 or less, no harm. |
So anyhow, I started reviewing my client’s sources of income and withholding, and here’s what I found (income amounts adjusted for annual increase where applicable):
| Source | Income | Withholding |
| Interest | $550 | $0 |
| Dividends | $550 | $0 |
| IRA Distributions | $28,000 | $4,000 |
| Pension | $13,000 | $2,000 |
| Social Security | $39,000 | $4,000 |
| Totals | $81,100 | $10,000 |
Projecting income tax for 2017, we found the following:
| Interest & dividends | $1,100 |
| IRA Distributions | $28,000 |
| Pension | $13,000 |
| Taxable Social Security* | $20,960 |
| Adjusted Gross Income (AGI) | $63,060 |
| Standard Deduction** | $15,200 |
| Personal Exemptions | $8,100 |
| Taxable Income (AGI minus Std Ded & Exemptions) |
$39,760 |
| Tax | $5,031.50 |
| Withholding | $10,000 |
| Refund or (payment) | $4,968.50 |
Now, reviewing the withholding amounts, it’s obvious that there are three places to reduce excess withholding to rectify this situation. One could stop the withholding altogether from the Social Security benefits, for example, and the result would be a refund of $968.50 – giving him access to $4,000 of his refund throughout the year. In other words, instead of $2,916.67 each month, his and his wife’s SS benefits could be $3,250.
Likewise, he could eliminate the $2,000 of withholding from his pension. This single move would bring down his refund to $2,968.50, bumping up his pension payments to $1,083 per month instead of $916.67.
Lastly, he could reduce his withdrawal from the IRA by $4,000, which would begin to make other changes in his overall tax situation. He’s making the withdrawal in that amount by choice in order to cover his income needs. So truly what he needs from the IRA is $2,000 per month, since he needs income of approximately $5,800 a month for his living expenses. Below is the outcome if he reduces his overall IRA withdrawal by the amount of the withholding, $4,000 (since it’s all excess withholding).
| Interest & dividends | $1,100 |
| IRA Distributions | $24,000 |
| Pension | $13,000 |
| Taxable Social Security* | $17,560 |
| Adjusted Gross Income (AGI) | $55,660 |
| Standard Deduction** | $15,200 |
| Personal Exemptions | $8,100 |
| Taxable Income (AGI minus Std Ded & Exemptions) |
$32,360 |
| Tax | $3,921.50 |
| Withholding | $6,000 |
| Refund or (payment) | $2,078.50 |
When we reduce his IRA distribution by $4,000 ($333.33/month, all of which was being withheld unnecessarily), his taxable Social Security income adjusts*. Now his taxable SS is only $17,560. So reducing his IRA withdrawal by $4,000 and thereby reducing his withholding by $4,000 results in a total tax of $3,921.50 – and he still has a refund coming in the amount of $2,078.50!
Keeping in mind that he has an income requirement of $5,800 per month, we make another adjustment to his withholding – we eliminate the $2,000 of withholding from his Pension payments. By doing this we can reduce his IRA withdrawals by an additional $2,000 per year.
| Interest & dividends | $1,100 |
| IRA Distributions | $22,000 |
| Pension | $13,000 |
| Taxable Social Security* | $15,860 |
| Adjusted Gross Income (AGI) | $51,960 |
| Standard Deduction** | $15,200 |
| Personal Exemptions | $8,100 |
| Taxable Income (AGI minus Std Ded & Exemptions) |
$28,660 |
| Tax | $3,366.50 |
| Withholding | $4,000 |
| Refund or (payment) | $633.50 |
You guessed it, this drops his taxable Social Security again. Only $15,860 is now taxed, and his total tax is down to $3,366.50 – and he still has a refund of $633.50 coming!
Taking it a step further, we can reduce the withholding on his Social Security payments by $1,000 – so that now he has only $3,000 being withheld. Covering his income need only requires a withdrawal of $21,000 from his IRA – which adjusts his taxable Social Security down, so that only $15,010 is taxed. His resulting tax bill is now only $3,089. When he files his return, he’ll owe a total of $89.
| Interest & dividends | $1,100 |
| IRA Distributions | $21,000 |
| Pension | $13,000 |
| Taxable Social Security* | $15,010 |
| Adjusted Gross Income (AGI) | $50,110 |
| Standard Deduction** | $15,200 |
| Personal Exemptions | $8,100 |
| Taxable Income (AGI minus Std Ded & Exemptions) |
$26,810 |
| Tax | $3,089 |
| Withholding | $3,000 |
| Refund or (payment) | ($89) |
Let’s try one more step: drop the withholding on Social Security benefits to $2,000. Or easier, leave the pension withholding as it is and eliminate withholding on the SS payments. Because of this, we can reduce the IRA withdrawal to a total of $20,000. This drops the taxable Social Security down to $14,160 and his tax down to $2,811.50! After his withholding of $2,000, he will owe $811.50 in tax.
| Interest & dividends | $1,100 |
| IRA Distributions | $20,000 |
| Pension | $13,000 |
| Taxable Social Security* | $14,160 |
| Adjusted Gross Income (AGI) | $48,260 |
| Standard Deduction** | $15,200 |
| Personal Exemptions | $8,100 |
| Taxable Income (AGI minus Std Ded & Exemptions) | $24,960 |
| Tax | $2,811.50 |
| Withholding | $2,000 |
| Refund or (payment) | ($811.50) |
Throughout this example, the net amount of income received each month remains roughly the same. In every instance there is approximately $5,800 per month to live on. In the end though, he’s paying $2,220 less in taxes and the IRS is loaning him $811.50 interest free through the year. That’s a reduction of 44% in taxes!
So – when you see a high refund on your tax return, don’t look at it as a “gift”. It’s a pretty expensive gift if that $4,968.50 has cost you an extra $2,220 in taxes!
* Taxation of Social Security is very complicated. See the article How Taxation of Social Security Benefits Works for more details.
** The client in question and his spouse are both over age 65, so their Standard Deduction is increased to a total of $15,200.
Sterling Raskie, MSFS, CFP®, ChFC®
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By taking out less from your taxable IRA now it leaves an increased required withdraw in the future. This required increase may push some people into an increased Medicare payments or a higher tax bracket. Overall it is also a case of pay me now or pay me later for the tax on IRAs. This assumes income is pretty much fixed from social security and pensions. I watch the Medicare brackets when taking any extra money above the RMD for the IRA. Once the RMD is satisfied any unneeded extra withdraws are transferred into my Roth (of course these are taxable). An extra $1 of income can jump the Medicare tax by hundreds of dollars if one is not careful. Having a greater % in a Roth and less in a conventional IRA gives me a good feeling in that I have more control of my income each year and a feeling that I have saved more after tax income for the future.
Sounds like you’ve got it under control!
This is why we often recommend that folks consider using their IRA money first and delay Social Security – this reduces RMD later (perhaps avoiding Medicare/taxation issues) and provides a higher percentage of your income at the lower inclusion rate, maximized at 85%.
I am no CPA, but I wasn’t aware that the IRS assesses a penalty based on how many years in a row you under-withheld. As far as I know the penalty is assessed in any year when you under-withheld, regardless of whether you under-withheld the year before or not.
If your under-withholding is over $1,000 this year and it wasn’t over $1,000 last year, there generally is not a penalty. If your past year was over $1,000 and this year is over as well, there definitely will be a penalty. Sometimes when the under-withholding is extreme, like you have $10,000 under-withheld, you may have a penalty regardless of the prior year, as well.
Interesting. The one time I personally underwithheld, it was for $1020 or so. I checked the box to have the IRS calculate the penalty for me. This explains why they never got back to me.
Most likely – sounds like it worked out okay for you!
Thanks so much for the interesting article and your suggestions. There is more to this story though. It is our understanding that as long as one paid at least 90% of the tax for the current year or 100% of the tax shown on the return for the prior year, whichever is smaller, even if one’s tax liability is >$1000 in consecutive years, one will NOT owe any penalties. If this is not correct, we would appreciate your directing us to the IRS link that contradicts this.
Yes, that’s another nuance to the withholding (rather, under-withholding) situation. So if your underpayment is over $1,000 but your paid-in tax is at least 90% of the prior year’s total tax, you’re still in good shape with regard to the under-withholding penalty.
What you said up top about the ideal outcome being owning a bit (clearly, a very small bit) of money to the IRS at the end of the year is the ideal outcome. This is almost profound — even though it shouldn’t be — because everyone seems to almost fetishize getting a tax refund, not realizing that they have in fact loaned the government money over a year interest-free. Sure, maybe interest rates are low today, but in an environment with decent interest rates and good investment opportunities, an interest-free loan seems like a ridiculous idea.
Thanks for the article and for the info – this is the first time I’m on this website and it’s clear you’re going into a significant amount of detail here.
Thank you for your comments, and welcome!
Is there a online calculator or spreadsheet to run trough scenarios? Trying to get as close to $0 as possible we are not retirement age yet.
I’m sure there are calculators available to run through scenarios, although I don’t have one in my hip pocket at the moment. Try googling for it. If I find something I’ll pass it along to you.
I love this! It really is so important to look at the whole picture and understand your own financial planning.
Thanks! Sterling and I were geeking out over this earlier today…
Good article. If I’m looking at this right, it appears only 45% of their SS benefits are taxed in the example with $24,000 of IRA distribution, despite their PI being more than $44,000. I thought PI needed to be less than $44,000 for less than 50% of the benefits to be taxed. Interesting.
That’s the rule of thumb, but there’s a transition “window” of income level where you get a blend if zero taxation and 50% inclusion with 85% inclusion…
This year was the first that we owed money to the IRS. I have to say–it definitely sucked more than getting a refund. ;) But it’s true that a gigantic refund actually isn’t a good thing. It means you’re depriving yourself of earnings from each paycheck unnecessarily. We’re adjusting our withholdings so hopefully next year we won’t be hit with a $900 bill, although I know that’s not too shabby.
It’s definitely counter-intuitive, and working down to a zero pay/zero refund may be the better way to go for most folks. It just can’t seem like a win if you’re paying out a big tax bill!
So take some of the extra monthly income and have your bank put it into a saving account. When your $900 tax bill comes due pay it from the savings account. Note this may not work for people who can not or will not live below or at their means, Sometimes feeling win or over other factors.
Absolutely!