Earlier this year, many annuitants were surprised to see the size of their monthly retirement checks shrink. This happened because the formula used to calculate withholding was changed because of changes in the tax law.
The change in law was not an under-the-table tax increase. Instead, the Dec. 31 expiration of the Recovery Act’s Making Work Pay tax credit caused the Internal Revenue Service to adjust the 2011 tax withholding tables — which increased the amount withheld.
However, the change does not likely affect the taxes owed by an annuitant. The increased withholding rate does not necessarily correspond to an increased tax liability. In this case, the additional money withheld from annuity checks will be refunded later — and without interest — if the amount withheld exceeds the amount owed for the year.
Withholding is only a deposit against your ultimate tax liability — a liability that comes due when you file your tax return and calculate the tax you owe. During the year, you are expected to estimate the taxes you’ll owe and make periodic deposits to cover this liability.
You can do this by making quarterly estimated tax payments or through automatic withholding from the checks you receive. In the former case, your checks are not reduced for tax withholding, but you are expected to estimate the appropriate amount and send a check to the IRS each quarter. In the latter case, the Office of Personnel Management, using information you’ve provided and a formula provided by the IRS, calculates the amount to withhold from each check and sends it to the IRS on your behalf. For most annuitants, this is the preferred method.
When you file your tax return, you calculate your tax liability for the year and add up the amount you contributed against that liability through estimated tax payments or automatic withholding. If you contributed more than you owe, you’ll receive a refund of the overpayment. If you contributed less, you’ll have to pay the difference along with your return. In the end, no matter how much you’ve contributed during the year, you’re obligated to pay what you owe, no more and no less.
How should one go about setting up the rate of withholding or depositing taxes against their tax liability? The answer depends upon a number of factors.
Some taxpayers enjoy, or even depend on, receiving a substantial refund at tax time. Although an economist would advise against this strategy of overwithholding as wasteful, since it is essentially lending the government your money without charging interest, I don’t mind it when it best suits your circumstances. For people who have difficulty saving money during the year or who don’t track where their money goes as they spend it, overwithholding can be an effective way to spend less and save more.
Other taxpayers have the means to pay all of their taxes at once, along with their returns. These people may be better off to skip withholding and settle up with the IRS at tax time. While this means they will pay a penalty for underwithholding, the penalty is often less than the cost of both borrowing money and the rate of return generated by a conservative investment strategy. An economist might favor this approach because it tends to maximize the taxpayer’s wealth.
If you don’t fit either of these profiles or are not sure what to do, you should strive to match your withholding to your ultimate tax liability. This avoids the penalties for underwithholding and a big tax bill in April without lending money for free.
Fortunately, you can adjust the rate of withholding against your annuity check. Unfortunately, it’s not always easy to predict how much you’ll owe in taxes for the coming year. The best place to start is with last year’s tax return. Take what you owed in 2010 and adjust for any factors that you expect to affect your liability this year. You can also adjust your withholding rate during the year to accommodate changes that occur along the way.
One approach I’ve used is to set your withholding to cover the lowest tax liability that you reasonably expect to incur, and then make an estimated payment or two during the year to supplement this withholding if necessary. This will let you avoid the process of changing your withholding rate, which can take some time and effort.
If you use a tax preparer, he should be able to advise you on withholding or estimated tax payments. If not, you’ll find a calculator and other resources at www. opm.gov/retire/index.aspx or by calling the OPM Retirement Information Office at 888-767-6738.
