How Much Tax Should I Withhold From My Pension?

How Is Social Security Taxed in Retirement?

There’s a good chance that you won’t owe taxes on Social Security if it’s the only source of income you receive during retirement. That’s because your income will be too low to be taxable. But if you have other sources of income, including otherwise tax-exempt interest income, a portion of your Social Security benefits may incur a tax bill.

More than half of Social Security beneficiaries pay some tax on their benefits. The percentage of families receiving Social Security benefits who have to pay income taxes on them was less than 10% in 1984 and more than 50% by 2015. This figure may rise to 56% between 2015 and 2050, according to the Social Security Administration (SSA).

The amount of your taxable Social Security benefits depends on your combined income or the sum of:

  1. 50% of all your Social Security benefits for the year
  2. The adjusted gross income (AGI), which is your total income minus adjustments to that income, such as deductions and exclusions
  3. Tax-exempt interest income, such as interest received on municipal bonds

Common sources of gross income include wages, salaries, tips, interest, dividends, IRA/401(k) distributions, pensions, and annuities.Common adjustments to gross income include health savings account (HSA) contributions, deductions for IRA contributions, student loan interest deductions, and contributions to self-employed retirement plans.

The level of your combined income determines the portion of your Social Security benefits that is taxable. The following chart indicates the percentage of your Social Security benefits that will be subject to tax at different levels of combined income:

Combined Income Taxable Portion of Social Security Individual Return   $0 to $24,999 No tax $25,000 to $34,000 Up to 50% of SS may be taxable More than $34,000 Up to 85% of SS may be taxable     Married, Joint Return   $0 to $31,999 No tax $32,000 to $44,000 Up to 50% of SS may be taxable More than $44,000 Up to 85% of SS may be taxable     Married, Separate Return   $0 and up Up to 85% of SS may be taxable

Be smart about pension tax withholding

Having a pension adds a valuable extra piece of financial support to help your retirement be more comfortable and secure. But along with extra income, you’ll also have to deal with the extra taxes that result. To avoid underpayment penalties to the IRS, setting up your pension tax withholding to address the income tax bill you’ll have to pay on your retirement income will go a long way toward preventing major headaches.

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Change in Withholding When You Start Social Security

Many retirees who have a pension are surprised by the increase in their taxes when they start Social Security. The amount of your Social Security benefits subject to taxation depends on your other sources of income. If your pension started a few years ago, and now you are starting Social Security benefits, you will likely need to increase your tax withholding.

Which Benefits Will be Taxed?

Under Michigan law, qualifying pension and retirement benefits include most payments that are reported on a 1099-R for federal purposes such as: defined benefit pensions, IRA distributions, and most payments from defined contribution plans and payments received before the recipient could retire under the provisions of the plan or benefits from 401(k), 457, or 403(b) plans attributable to employee contributions alone.  

Payments not reported in federal adjusted gross income are not taxable in Michigan and not subject to withholding. For example, distributions from a Roth IRA or a Roth 401(k) plan are generally not subject to pension withholding because those distributions are generally not taxable.  

The changes in tax treatment do not apply to Social Security, Military or Railroad Retirement benefits.

Standard Deductions for Retirees

The standard deductions for 2021 are used on tax returns filed in 2022. The standard deduction for 2021 is $12,550 for single taxpayers and married taxpayers filing separately, $25,100 for married taxpayers filing jointly, and $18,800 for heads of household. The standard deduction for married couples filing jointly increased for the 2022 tax year to $25,900, tp $12,950, and to $19,400 for heads of households.

Taxpayers who are 65 years of age or older (whether or not they are retired) are eligible for an extra standard deduction of $1,700 for 2021 ($1,750 in 2022) if they are single or heads of household (and not married or a surviving spouse) and an extra $1,350 for 2021 ($1,400 in 2022) per senior spouse if they are married filing jointly, married filing separately, or a qualified widow(er).

Standard Deductions for Taxpayers Age 65 or Over, Tax Year 2021 Filing Status Standard Deduction Senior Bonus Total Deduction Single $12,550 $1,700* $14,250 Married filing jointly or qualified widow(er) $25,100 $1,350 per senior spouse $26,450 or $27,800 Married filing separately $12,550 $1,350 $13,900 Head of household $18,800 $1,700* $20,500

Standard Deductions for Taxpayers Age 65 or Over, Tax Year 2022 Filing Status Standard Deduction Senior Bonus Total Deduction Single $12,950 $1,750* $14,700 Married filing jointly or qualified widow(er) $25,900 $1,400 per senior spouse $27,300 or $28,700 Married filing separately $12,400 $1,400 $13,800 Head of household $18,650 $1,750* $20,400 Source: Internal Revenue Service

* If not a surviving spouse, otherwise $1,350 in 2021 and $1,400 in 2022.

If your taxable total income falls below these amounts, you won’t owe any taxes. You usually won’t even have to file a tax return (unless you are married filing separately), though you may want to anyway. Filing a return allows you to claim any credits for which you might be eligible, such as the tax credit for the elderly and disabled or the earned income credit. Filing a return also ensures that you receive any refund you may be owed.

Taxpayers who itemize deductions may not claim the standard deduction and bonus amounts. Recent increases in the standard deduction amounts mean the threshold at which older taxpayers benefit more from itemizing than taking the standard deduction is higher. These higher levels may affect your decisions about when to make charitable donations or pay other deductible expenses. You may be able to benefit from itemizing in some years if you can lump large itemizable expenses together so that they fall within a single tax year.

Benefits from Employment that was Exempt from Social Security

Recipients born between January 1, 1946 and December 31, 1952 and recipients born after 1945 who were retired on January 1, 2013 who receive qualified pension or retirement benefits from employment with a governmental agency that was not covered by the federal Social Security Act (SSA) are entitled to a greater retirement/pension deduction or Michigan Standard Deduction. Employment that is not covered by the SSA is employment where the worker did not pay Social Security taxes and is not eligible for Social Security benefits based on that employment. Almost all employment is covered by the federal SSA. The most common instances of pension and retirement benefits from employment that is not covered by Social Security are police and firefighter retirees, some federal retirees covered under the Civil Service Retirement System and hired prior to 1984, and a small number of other state and local government retirees.

The deduction limit is increased by $15,000 for each recipient with benefits due to qualified employment that was exempt from the SSA. The 2018 limits for the Michigan standard deduction or the deduction for pension and retirement benefits are as follows:

  • Single filers (or married, filing separately) born in years 1946 – 1952 may claim a Michigan standard deduction of $35,000.
  • Joint filers where the older spouse was born in years 1946 – 1952 and one spouse has benefits due to qualified employment that was exempt from the SSA may claim a Michigan standard deduction of $55,000. If both spouses have benefits due to qualified employment that was exempt from the SSA the couple may claim a Michigan standard deduction of $70,000.

If both spouses have benefits due to qualified employment that was exempt from the SSA the couple may deduct qualified pension and retirement benefits up to $70,000.

Filers born after 1952 who have reached the age of 62.

  • Beginning January 1, 2018, recipients born after 1952 who received qualified retirement benefits from employment that exempt from SSA and were retired as of January 1, 2013, may deduct $35,000 for single or married filing separately filers or $55,000 for joint filers of retirement and pension benefits. If both spouses on a joint return qualify, the maximum deduction increases to $70,000.

Withholding tables that incorporate these larger deductions are available. Pension administrators can also program the appropriate withholding amount using the formulas below for benefit recipients born after 1945 and before 1953.

Withholding = [Pension subject to tax – monthly pension deduction – (allowance per exemption x number of exemptions)] x 4.25%

2021 Withholding = [Pension subject to tax – monthly pension deduction – (allowance per exemption x number of exemptions)] x 4.25%

For 2021 the monthly pension deductions and personal exemption amounts are

Single pension deduction per month = $35,000/12 = $2,916.67 Married pension deduction per month = $55,000/12 = $4,583.33 Personal exemption allowance = $4,900/12 = $408.33 per exemption

How are pensions taxed?

Pensions are fully taxable at your ordinary tax rate if you didn't contribute anything to the pension. If you contributed after-tax dollars to your pension, then your pension payments are partially taxable. If the payments start before age 59 1/2, you may also be subject to a 10% early distribution penalty.

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