Do I Need To Pay Estimated Quarterly Taxes In Retirement?
The U.S. tax system is a pay as you go system. You must pay taxes on your income throughout the year. Failure to do so can result in the IRS imposing penalties on you.
When you are working as an employee, your employer withholds taxes based on information you provide to them on Form W-4. This typically fulfills the pay as you go requirement.
When you retire, you may derive income from any combination of investments, Social Security, a business, consulting, or part-time work. As such, you may need to pay estimated quarterly taxes.
Do you understand who needs to pay quarterly estimated taxes, how to determine how much you owe, how and when to pay, and penalties for failure to meet these requirements?
What is Estimated Tax?
You pay estimated tax on any income that isn’t subject to withholding. This includes:
- Self-employment income
- Dividends and Interest
- Taxable alimony payments
- Other taxable income including retirement account distributions and Social Security when voluntary withholding was not elected.
Who Needs To Pay Quarterly Estimated Taxes?
You generally need to pay estimated taxes if:
- You expect to owe at least $1,000 at the end of the year after subtracting any withholding and refundable tax credits, AND
- Your withholding and refundable tax credits are expected to be less than the smaller of:
- 90% of the tax shown on your current year’s return, OR
- 100% of the total tax owed on your prior year’s return (110% if your AGI is >$150,000 and you file married filing jointly).
If you derive most of your income from self-employment, you most likely will have to pay quarterly estimated taxes.
If your retirement income comes from investments, Social Security, or part-time work performed as an employee, you have the option to pay estimated taxes. You also have the option of withholding income from these sources.
The IRS provides a tax withholding estimator to help determine the appropriate amount of tax to withhold.
For retirees getting most of their income from investments, you can have taxes withheld from distributions. This is typically the default setting at brokerages for retirement accounts. For example, Vanguard withholds 10% of distributions from traditional, SEP, and Simple IRAs.
You have to manually opt out of withholding if you prefer to pay estimated taxes. You do this by completing IRS Form W-4P.
This may be preferable when performing Roth IRA conversions and wanting the full amount to be rolled into the Roth account. This assumes you have money from other sources that can be used to pay the required taxes on the distribution.
If distributions are made outside of the United States, the 10% withholding is mandatory. You may not opt out.
Social Security does not withhold any portion of your benefits by default. If you want to withhold money from your Social Security benefits, you have to elect to do so with IRS Form W-4V.
If you work a W2 job, you can increase the amount your employer withholds to avoid paying estimated quarterly taxes. You do this by completing IRS Form W-4 and giving it to your employer, who will withhold the tax for you.
How Do You Estimate Taxes?
Find instructions for estimating taxes on IRS Form 1040-ES. This includes an estimated tax worksheet. If you haven’t had to pay estimated taxes and/or your situation is expected to be different than it was in the past, this worksheet is very helpful.
Since our household has been paying estimated taxes and we don’t expect our situation to change much this year, we simply use our past year’s taxes as a guide. We pay estimated taxes plus withholding from my wife’s job equal to 100% of last year’s taxes.
This satisfies the requirement of paying 100% of the total tax owed on our prior year’s return. However, if your situation is changing substantially, this may cause you to substantially over or under pay your taxes, leaving you with a larger tax bill or refund than you may desire at the end of the year.
When and How Do You Pay Quarterly Estimated Taxes?
As with most things IRS related, this is not simple and straightforward. The term quarterly taxes is somewhat of a misnomer, as they are not actually due every three months.
Assuming you pay taxes based on a calendar year, estimated quarterly taxes are due the 15th (or the first business day after if the 15th falls on a weekend or holiday) of April, June, and September of that year, with the 4th payment due in January of the following year.
The IRS expects to be paid. Thus, they do make paying the taxes easy.
You find tax vouchers on Form 1040-ES which can be mailed in with a payment. You also can pay online by credit card for a small fee, which I personally choose if it helps me to meet credit card sign-up bonuses that far outweigh the fee.
Are There Penalties for Failure to Pay Quarterly Estimated Taxes?
The IRS’s pay as you go system helps to insure that people aren’t surprised by a large tax bill at the end of the year that they may not be able to pay. People reading this blog tend to have substantial savings and may prefer to just pay once a year. But is that wise?
In a word. No.
Penalties and interest are charged for failure to pay estimated quarterly taxes on time. There are means to appeal penalties for late or non-payment due to “reasonable cause.”
However, as with all tax topics, it is best to learn the rules and play within them. No one enjoys paying taxes, but it beats dealing with the consequences of not paying what you owe!
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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at email@example.com.]
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Good summary. With interest rates on short-term savings so low, I’ve been paying my full year estimated taxes on the first estimated due date (you can always true-up later in the year if your income increases materially). The tiny amount of forgone interest income is worth being “done with it”. If online savings rates improve dramatically I may consider going back to quarterly. I also used a credit card last year to snag one of those bonus offers – great tip!
I agree. It’s similar to the conventional wisdom that you don’t want a refund b/c you are just loaning the IRS money interest free. That makes sense in theory, but if you are just keeping it in a savings account where you’re lucky to get around .5% interest, it makes sense to make life as simple as possible.
The handy thing about Required Minimum Distributions is withholding 100% of last year’s taxes from your distribution One Time late in the year. Love that. The IRS considers that as withheld “throughout the year”.
Taxes withheld by W-4 are treated as if they were paid throughout the year – so if you determine that you are underpaid you can “catch up” by increasing W-4 withholding and avoid penalties due to not filing quarterly payments.
I’ve been paying estimated taxes for quite a while, even when I was working. my 1st year in retirement Im going to have to do a little guessing as our W2 income dropped dramatically, it’s pretty much all investment income. Estimating investment income is PITA, but I tend to use past dividend and cap gains history as a guide, although this year is bound to be a wild card given the down market. curious if others are expecting dividends and cap gains to be much lower this year.
I agree it is a PITA to try to estimate, which is why we tend to go with the option of paying 100% of last year’s taxes. But as you note, if income drops dramatically such as in first year of retirement that can mean paying far more than necessary which also means figuring out how to come up with that money.
My $.02 is that market impacts on income are really driven by your investing style. For us, our taxable investments are in broad based index funds. We have virtually no capital gains, other than when we sell and we have a good bit of control over that by choosing which specific tax lots we sell. I don’t personally anticipate a large cut in dividends, as overall the economy (different than the stock market) seems to be doing OK. And with starting dividend rate so low already, it wouldn’t make a big difference for our tax bill even if dividends were cut. Our only other taxable investment income is from interest from savings account (also too little to matter) and I Bonds (deferred until we sell them). So to answer your question, no I don’t think our investment income will be much different this year.
I use the tax estimation calculator tool provided by the Colorado Tax-Aide program (cotaxaide.org) every year to determine how much I need to pay quarterly. Try:
Thanks for sharing that tool Fred.
I believe that if you have any taxes withheld on periodic payments such as pensions or social security, then the IRS considers you to have been paying taxes throughout the year, such that there’s no need to pay tax mid-year on, say, a Roth conversion or some large unexpected income. Others have alluded to this, but to be clear, I believe this means that if one has any taxes in such income withheld, they need not concern themselves with prepaying anything else.
My understanding is that you are correct IF you meet the criteria related to ultimately owing <$1,000 and meeting the other criteria related to your current or last year's tax liability. If not, you would still have to pay estimated taxes. Using myself as an example, my first few years writing this blog, I made very little income and we filed MFJ. As such, my wife's withholding allowed us to meet our obligations. In the past 2 years, since releasing my book and having more blog income, I have needed to pay estimated taxes as well (or I suppose we could have elected to withhold even more from her paycheck to meet our obligation.) Best, Chris
Hi Chris I agree with your points here. One thing to add though is that if your income is not linear through out the year and you pay based on when the income was realized (such as when a roth conversion was done or some other later in the year income). I believe there is a form to fill out to show your income was not linear and justify paying more in later quarters. Thanks for the article..
Thanks for the thoughtful feedback Bruce. You are correct that there is yet another form that I did not link, Form 2210 Schedule AI, for people who have uneven income throughout the year.
Chris, can you go a bit more into detail as to how you would avoid having tax withheld on a ROTH conversion, so as to convert the highest amount, please? (You could pay taxes due on the conversion by either increasing withholding elsewhere (ex., on pension income) or by making estimated tax payments.). It seems one might want to use Fed W-4R, rather than Fed W-4P (the former appears specifically meant for such non-periodic distributions, while the latter can be used for such only until December, 2022, if my quick perusal was useful). Suppose Vanguard is the custodian of both the traditional IRA and the ROTH IRA. Are they also the “payer” for these purposes, and you file the W-4R/W-4P with them? Of course, then there is the *State* part of the equation, if there is mandatory State withholding …. One shouldn’t forget to address that part as well.
My experience with performing Roth conversions is with Vanguard, so I can use that as an example. Assume I want to convert $20,000 in a year as a nice round number. Vanguard would automatically withhold 10% as their default, as the first step of the conversion is essentially a distribution from the tax-deferred IRA. So, I would ultimately convert only $18,000 which would then grow tax-free growth and not be subject to tax with distributions from the Roth, with the remaining $2,000 withheld for taxes. However, if I have an extra $2,000 in my savings account that I can use to pay the taxes, I can ask Vanguard to not withhold anything, convert the full $20,000 which will all then be subject to tax-free growth and future distributions, and pay the tax from my taxable savings. I think this addresses your question. If not, you can let me know.
Re: state taxes. You are correct. I have not figured out an effective way to address state taxes while writing for a broad audience. The state laws are just too different. That said, I should have at least mentioned that aspect. Good catch!
Thanks for the response, Chris! So you do not need a W4-P *or* W-4R… You simply instruct Vanguard to not withhold taxes on the conversion? Seems simple enough … 🙃
I don’t recall the specifics, as I did this helping my parents and we started doing the conversions a few years ago. I will have to see if they remember or if they can check through their records, but if we needed to submit a form it would have only been once the first time we changed the election.
We still have too much income from my wife’s job for Roth conversions to make sense for ourselves, so I’ve never actually had to do it myself.
Thanks, again, Chris. I called Vanguard, and it appears one only needs tell them to not withhold taxes. (Of course, Vanguard will report the distribution to the Feds — and State, I reckon, if applicable — so you need ensure you square up on the taxes.). They have a retirement team that can go into the weeds more, but I held off speaking to them for the moment.
Hi! Question: In a scenario where the only source of income in one particular year is capital gains (ie. selling a chunk of stocks), are estimated payments required?
My understanding is that there would be. However, remember that you do not have to pay estimated taxes if you will owe less than $1,000 on your tax bill at the end of the year. So don’t forget to factor in your standard deduction (or itemized) + any tax credits that would lower your tax burden. This is where the form I linked to or the calculator shared in the comments would be helpful.
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