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We’re not overpaying. No, we’re not overpaying. We’re not overpaying anymore. The tax code’s complicated, boring, and overrated. You don’t want that, you want a pro. One thing that you should know: this is a radio show. It’s not tax advice, don’t take it that way.

Steven Jarvis:     Hello everyone, and welcome to the next episode of the Retirement Tax Services Podcast, Financial Professional’s Edition. I am your host, Steven Jarvis, CPA. And in this show, I teach financial advisors how to deliver massive value through tax planning. Continuing today with sharing experiences from this last tax season, questions that have come up from clients and things we are able to do to help educate and implement tax strategies so that clients are not overpaying the IRS and have better expectations, better experience with taxes overall.

One of the things that came up a few different times this year was this question of how do taxes actually get paid in retirement? More often than not, I hear this from clients who are transitioning into retirement, but this will keep coming up even a few years into retirement, especially as income sources change or are turned on or turned off, things like Social Security starting, whatever it might be. But this question comes up quite often, especially for clients who spent most, if not all of their career as W-2 employees.

For so many taxpayers, there’s really no need to actively think about how taxes physically get paid. A lot of people hardly even think about the fact that each paycheck there’s the gross amount and then some federal stuff that comes in, maybe some state stuff that comes out, using our real technical terms here, like stuff. So for so many people it’s, “Hey, I get my paycheck every month, every two weeks, whatever it might be. And then at the end of the year, I file my tax return and I settle everything up.” And so it can be a challenging transition for people who don’t have someone in their corner helping them with this, that first year that they don’t have that W-2 job anymore. Or the first full year is going to have an even bigger impact.

When now we switch from our whole career, someone has taken care of this for us, we haven’t hardly had to think about it, to now if we don’t do something, we don’t have a plan for it, we can end up paying significant penalties and end up with nasty surprises come tax time when we have to write large checks to the IRS. Because while the IRS doesn’t force us, through making our employer take the money out directly, it doesn’t force us to pay throughout the year, the IRS is still only so patient and they are going to expect us to get all those taxes paid. And if we pay those taxes through estimated payments or year end payments, there’s also going to be penalties associated if we didn’t get enough paid during the year.

So when we talk about how do taxes get paid in retirement, we ultimately still have the same options we did before, it’s just, again, this is the first time this has been relevant for many people. The taxes can either be withheld or we can make estimated payments. Now, that’s the overly simple way to put it, as those are the two possible outcomes, but as we get into retirement, we might not always have those options available to us on each income source. So let’s talk about a few different places that retirees are getting income from and how the taxes might get paid. So we’ve definitely talked about it on the show before, but Social Security is definitely an example I always like to bring up on this topic, because some people are surprised at times to find out that Social Security is taxable to begin with.

But then by default, no taxes are withheld from Social Security. Not only are no taxes withheld by default, but most people aren’t ever even informed that they can have taxes withheld from their Social Security checks. We’re going to use form W-4V to make that election, which was talked about a couple weeks ago on the show, but want to make sure that’s top of mind as we’re having this conversation about how do or how can taxes get paid in retirement? So Social Security is certainly one option and an income source where if we so elect, we can have taxes withheld.

Now, for our clients who have done a great job saving and investing and have a portfolio of securities, they likely will be receiving some dividend income, or they might have capital gains distributions from mutual funds or other holdings that are going to pay out those capital gains distributions, typically towards the end of the year. Now, these are two sources of income, both the dividends and the mutual fund capital gains distributions, that generate income, which means they generate taxes, but there aren’t taxes withheld and there really isn’t the option to withhold taxes. There isn’t a withholding form for what percentage of my dividends would I like held aside for taxes.

Now, we absolutely can make estimated payments during the year, but the point here is that this isn’t going to happen by default. This isn’t going to happen unless we are proactive and have an intentional plan. And what can be especially frustrating in this area is that for many clients, they’ve received these income sources before retirement, but retirement might be the first time that this kind of bites them as far as the tax impact of it. Again, if we’ve spent most of our career, most of our earning years with W-2 wages, there’s a good chance that not only were we paying our income tax on the wages themselves, but a lot of times we’re adjusting our withholdings based on our total tax liability.

And so I’ve definitely worked with clients who have, whether they realized it or not, have increased their withholdings to cover more than just their wages. And that’s probably not the way they’re thinking about it and so when they get to retirement and all of a sudden their W-2 withholdings turn off, they’re not thinking about the fact that wait, I had other income sources that the taxes were getting paid through those withholdings, and now I need to do something different to cover those. So that’s certainly an area that we can proactively work with clients to make sure that we’re monitoring during the year and updating or doing whatever makes sense for the specific client’s situation as far as making sure that taxes are withheld from other sources to cover that income or that estimated payments are being made so again, there aren’t surprises or penalties being paid at tax time.

Coming right alongside those sources of income would of course be capital gains income, which regardless of where those capital gains are being generated, whether that’s from a portfolio of securities or the sale of a house or the sale of a business, as capital gains are generated, at least in my experience, there isn’t the option to have taxes withheld there. And there’s varying practices as far as setting those taxes aside or setting the cash aside for the taxes versus paying it immediately. Regardless of the timing that the tax is being paid, we want to make sure that as we’re advising clients, that it’s very clear that taxes will be due. And quite often, just from a behavioral standpoint and an expectation standpoint, paying the taxes when the gains are generated can provide the best outcome, again, from that expectations and what’s actually going to happen in practice.

Because what I see too often is that clients will get to tax filing time, the joy of the gain has worn off because that was months and months ago, and now the pain of paying the taxes that they weren’t actively thinking about is significantly higher. Whereas if as the gains are generated, we’re paying the taxes at the same time, the sting might not feel as bad and we don’t have that same shock and disappointment later when that big check needs to be written. So we want to make sure we’re setting those expectations. We want to make sure that the client understands the plan for paying those taxes, that those funds are being set aside, that we’re avoiding those unfortunate surprises.

What I also see at times with retired taxpayers, whether newly retired or further into retirement, is taxpayers who are having business income for the first time in their career. Again, looking at people who have spent a lot of their earning years as W-2 employees, there might be opportunities for some kind of side gig, for some kind of consulting or small business that they think of as more of a hobby, whatever that might look like. Had a couple come up this year. One was a client who had the opportunity to be an expert witness. Another was a client who, as they’re transitioning to retirement, they wanted to scale back a little bit and with their employer, that meant going from being a W-2 employee to a 1099 employee.

So for our business owners out there who have been longtime business owners, the idea of making estimated tax payments is nothing new and is just part of their normal operations. But again, for someone who’s spent so long as a W-2 employee, it’s not just that they’re going to be new to making estimated payments, but trying to figure out how much to pay can come with some uncomfortable surprises as well. I was having a conversation with one particular couple this year who was in that situation where they’re going from being W-2 employee to 1099 employee. And thankfully they were being proactive, they’d started thinking ahead of, okay, great, now that I’m a 1099 contractor, there’s some additional expenses I can deduct to help offset that income. So they’d come with questions on that. We talked through some of the things they’d be able to deduct. But their starting place for how much should I expect to pay in taxes was really just focusing on, okay, well what was my income tax rate in the previous year?

And so we had to talk through, okay, now this is business income. Even though in their head, they were kind of still thinking about it as well, I’m an employee, I’m just getting paid a little differently. Well, that’s unfortunately not the way the IRS looks at it. You are now a business owner and what comes along with that is self-employment taxes. And so now we’re not looking at, are you in the 22% bracket or the 24% bracket? On top of that, we have to say, you are now responsible for both the employee and employer portions of payroll taxes. And this isn’t… For most people, we can’t just think about this as, okay, great. So my taxes went up 7.65%, which is half of the total self-employment taxes, because while as an employee, I was paying half that before anyways. In reality, most employees aren’t thinking about the fact that to go from gross wages to will actually hit my bank account, that those payroll taxes are coming out.

And so we’ve got to make sure it’s really clear that, okay, yes, we need to look and see, are you in the 22% or 24% bracket? And then we just need to add that 15.3% on top of there. That’s going to be an oversimplification because of course we get a deductive portion of that, but we want to make sure it’s really clear that as we’re making estimated payments, it’s not let’s make estimated payments of 20 to 25%. It’s probably closer to that 35% range that we need to be making estimated payments to make sure that we are staying in the IRS’s good graces, that we’re not putting ourself at risk of underpayment penalties.

I’ve talked before on the show about the advantages of withholding versus estimated payments, and that all still holds true in retirement. For clients who have qualified retirement accounts, tax deferred retirement accounts, as they’re making withdrawals from those accounts, that can be a great time to make sure that we are having taxes withheld and potentially having taxes withheld beyond just what’s due on that particular distribution, but to cover some of these other sources, again, depending on what that client’s specific situation is. For example, for our clients that have just started their first side hustle, their first business, it might be easier from the standpoint of it’s less likely that it’s going to get forgotten or not done on time to it might be easier to have taxes even for the business withheld from IRA distributions, as opposed to making those estimated payments. But again, we want to make sure that whatever the approach is, that there’s an intentional strategy to it and that everyone understands how that’s going to be taken care of.

If we do have clients make estimated payments, which certainly happens, really want to make sure that clients are doing that online. Now, if you’re an RTS member, go out to the retirementtechservices.com to the member’s section. We have a how-to guide that you can just give to clients, walking them through step by step with screenshots, how to make those online payments. If you’re not an RTS member yet, it’s certainly something you can create on your own, but being able to make this as simple as possible for your clients is definitely the way to add massive value in this process. Not just making the online payment easy for them, but helping them with things like let’s make sure that our estimated payments end with a number that corresponds with the quarter that we’re talking about. So for example, Q1, the payment would be 1,001, Q2, 1,002, and so on. These are just little things that make the experience better for the client as they have to make estimated payments.

As I’m recording this episode, it’s just been within the last couple of weeks that came out that the IRS had destroyed some 30 million returns, paper returns, that is. Not that that’s specific to making estimated payments, but for me it certainly reinforces the importance of doing everything we can with the IRS electronically and avoiding paper at all costs. I had several conversations with clients this year around how estimated payments are made, that essentially they acknowledged that the only reason they were still doing paper payments for their estimated payments is because that’s what they were used to and they didn’t want to take the time to figure out how to do it differently. And so that how-to guide was tremendously valuable for them. They were very, very grateful for it to be able to make that switch and be able to move on from that.

One other example that came up this tax season that’s related to how taxes get paid in retirement, I was working with a federal employee who had actually been receiving for a couple of years their pension from the Office of Personnel Management or OPM, which is who handles federal employee benefits. And during the year they had a change in their withholdings from their pension payments and didn’t realize it. Now, I don’t know the inner workings of OPM. I worked with the advisor who was collaborating with us on this client, who went back to try to figure out what had happened. And best we can all tell, OPM made a change without the client’s actual request.

So to wrap up this topic, this is definitely an area where you need to really get to know your client’s specific situation. For so many people, during their earning years, the focus is on funding different types of investments or accounts, whatever that might be, with one primary source of income. And as we get towards retirement and into retirement, this is going to be the first time for a lot of people that different sources of income are getting turned on, that this dynamic of how taxes get paid is going to dramatically change. So definitely a conversation we want to have as we’re leading up to this time period, not right when it starts. We don’t want to do this looking through the rear view mirror, we want to be looking through the windshield, letting clients know what’s coming, what to expect. And we want to be talking about this before the question comes up from the client so that we are taking away that anxiety, that concern around, “Oh, wait a second. How does this piece get taken care of?”

So as far as action items go on this topic, of course, we always want to be getting tax returns. Even when we’re still contributing and funding these different investments or potential income sources, the tax return can tell us a lot about where the funds are going and what potential income sources might be available later. The next action items is to make sure that in your process for really just about any financial planning strategy, that you’re including in your process, ensuring there’s a plan for how the taxes get paid. Whether we’re talking about capital gains harvesting or our income distribution strategies or whatever it might be, there’s a tax impact in everything you do. Take responsibility for making sure you see this through to the end, which includes the taxes getting paid and then being reported correctly, which is why we put such an emphasis, or one of the reasons we put such an emphasis on getting the tax return. That’s the only way we’re going to be able to do that accurately and make sure it happened correctly.

As I mentioned before, for RTS members, we already have a how-to guide on online payments. If you’re not an RTS member, your action item is to create a how-to guide so that you can make this as easy as possible for your clients. Have someone on your team go through the process themselves and take screenshots along the way so you can share that with clients. Of course, we always appreciate our listeners leaving us a five star review and providing comments so that we can make sure this continues to be valuable and reach more people. And for everyone listening, really appreciate you being here. Until next time, good luck out there and remember to tip your server, not the IRS.

We’re not overpaying. No, we’re not overpaying. We’re not overpaying anymore. The tax code’s complicated, boring, and overrated. You don’t want that, you want a pro. One thing that you should know: this is a radio show. It’s not tax advice, don’t take it that way.