The amount of taxes you should withhold from your pension is dependent on your tax rate and your household sources of income and deductions. Basically, you add up all your sources of income and subtract your deductions to get your taxable income.
Your taxable income determines your tax bracket, and you can use the tax bracket to estimate how much tax to withhold. It's clear that higher amounts of income are taxed at higher rates. The good news is that in retirement, it's likely you'll be in a lower bracket than when you were working.
Tax planning can help you figure the right amount to withhold. With tax planning, you can put together a pretend tax return, called a tax projection. As you transition into retirement, you'll want to work with financial professionals to help you with this.
How to calculate what you owe
Many factors can affect your income taxes, but there are ways to estimate your tax bill. Let's say your total income in a given year will be $20,000 from a pension and $30,000 from the money you withdraw from your IRA. You can fill out a "pretend" tax return (not for filing, just for your information), and you may find out that you will owe $5,000 in taxes. This is a 10 percent rate, so you will have 10 percent in federal taxes withheld directly from your pension and IRA distribution so that you receive $18,000 from your pension and $27,000 from your IRA.
When your tax situation changes, you will want to adjust your tax withholding. Say, in your first year of retirement you have a salary part of the year and you have a spouse who's still working. You may need to withhold a larger amount of taxes from your pension for the year. In the subsequent year, your income may change again, and that means you should adjust your tax withholding.
The following events may trigger a need to change your tax withholding in retirement:
Keep an eye on your IRA distributions. And you may have cashed out of an old 401(k) account early in the year and then have forgotten about that by the time you file your tax return. Also, although you are allowed to work while collecting Social Security, there are special rules regarding that you should be aware of.
Don't let yourself be surprised by the amount of taxes you owe. It's best to plan that whenever you withdraw money from any accounts in retirement, you should ask about the tax implications. It's better to plan ahead than to get behind in taxes.
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