Need to Know Tax › Retirement and seniors
Paying as you go
Estimated payments: who has to make them, and the safe harbor
For retirees whose pension, IRA and Social Security withholding no longer adds up to the tax, and for anyone who got a penalty letter last year and does not know why. Two tests excuse the penalty entirely, and one of them is a number you already know in January.
The tax system is pay-as-you-go. Tax is supposed to arrive during the year, through withholding or quarterly estimated payments, not in one check the following April. Pay too little as you go and there is a charge for the delay, figured like interest on the amount you should have paid each quarter and did not. That is the underpayment penalty. Working people rarely see it, because an employer withholds from every paycheck. Retirees see it all the time, because a pension, Social Security and an IRA are three payers that never talk to each other.
Why retiree withholding falls short
The pension plan withholds based on the Form W-4P you filed, often years ago, treating the pension as your only income. Social Security withholds nothing unless you ask. And the IRA custodian withholds 10% of a withdrawal unless you say otherwise, which is rarely right for someone in the 22% bracket whose withdrawal also makes more of their Social Security taxable. Each payer does what it was told. Together they come up short, and the shortfall arrives as a balance due plus a penalty that nobody can explain.
Worked example: three payers, one shortfall
A married couple, both 70: a $36,000 pension, $40,000 of Social Security, and $30,000 of IRA withdrawals. Taxable Social Security $34,000 (the 85% ceiling); taxable income after the $47,500 of deductions about $52,500; federal tax about $5,800.
| Payer | What it withheld, and why | Amount |
|---|---|---|
| Pension | W-4P filed in 2019 as if the pension were the only income | $1,100 |
| Social Security | Nothing; no W-4V on file | $0 |
| IRA custodian | 10% default on $30,000 | $3,000 |
| Total paid in | $4,100 | |
| Tax | $5,800 | |
| Balance due in April | $1,700 | |
| Underpayment penalty? | Paid in 71% of this year’s tax; last year’s tax was $4,600, so 100% of last year was not met either | Yes, about $70 |
The penalty is small; the surprise is the point. The fix for next year: W-4V to Social Security at 7% ($2,800), and the IRA withholding raised from 10% to 12%. Then nothing is owed in April and nothing is mailed quarterly.
The safe harbors
Two tests excuse the penalty entirely. Meet either one and there is no penalty, however large the balance due. The balance itself is still due April 15.
| Test | Amount |
|---|---|
| This year’s tax | 90% |
| Last year’s tax, if last year’s AGI was $150,000 or less | 100% |
| Last year’s tax, if last year’s AGI was over $150,000 | 110% |
Also no penalty if the balance due after withholding is under $1,000, or if you had no tax liability last year as a full-year U.S. resident.
The “last year’s tax” test is the useful one, because it is a number you already know in January: the total tax line on last year’s return. Whatever happens this year, a bonus, a Roth conversion, a sale, paying in 100% or 110% of last year’s tax means no penalty. The rest is owed in April, and you keep the money until then. For a year with a one-time event, this is the whole plan: cover last year’s number, set aside the tax on the event, and pay it with the return.
Three fixes, in order of convenience
Withholding first. A new Form W-4P to the pension with an extra flat amount per payment. Form W-4V to Social Security, choosing 7%, 10%, 12% or 22% of the benefit. Form W-4R to the IRA custodian, picking any percentage instead of the 10% default. Withholding is treated as paid evenly through the year no matter when it comes out, so a shortfall discovered in November can be covered by having the whole year’s tax withheld from a December RMD. That trick does not work with estimated payments, which are credited only on the date paid.
Estimated payments second. Form 1040-ES, four equal payments, due April 15, June 15, September 15 and January 15. Pay online through IRS Direct Pay or your IRS Online Account rather than mailing a voucher; the payment is credited the day it is made and there is a record. Miss a quarter and the penalty runs on that quarter even if the year ends up fully paid.
The annualized method, for uneven income. If most of the income arrived late in the year (a December sale, a year-end bonus), Form 2210’s annualized method figures the penalty quarter by quarter on the income actually received by then, which can eliminate a penalty that the equal-payments assumption created.
And a checkup every fall, while there are payments left to make up a shortfall and a December RMD to carry the rest. Bring the pension statements and last year’s return to a preparer and ask what each form should say.
Behind the scenes
When a retiree’s return shows a balance due, a preparer does not stop at the number. The software applies the 90% test automatically, but the 100%-of-last-year test needs last year’s total tax typed in, and if the return was prepared elsewhere that figure has to be found before the penalty disappears. Then the shortfall is divided among the three payers and the new W-4P, W-4V and W-4R are written down, because the same balance will come back next year if nothing changes. The December-RMD withholding trick is checked last: if the client is taking an RMD anyway, one form to the custodian in November can replace four estimated payments.
The Colorado side
Colorado has its own underpayment penalty, its own estimated-payment schedule and its own withholding certificate. Estimates go on Form DR 0104EP (verify) or through Revenue Online, on the same four dates, and are required when the Colorado tax expected after withholding is more than $1,000 (verify); the 90% and 100%-of-last-year safe harbors are mirrored (verify). At a flat 4.40% the shortfall is smaller, but it arrives in the same envelope, and it is more common, because pension and IRA payers withhold nothing for Colorado unless asked. For the couple in the example, Colorado tax after the retirement subtractions is a few hundred dollars at most; a Colorado withholding election on the IRA of 2% would cover it.
What to bring your preparer
- Last year’s complete return, for the total tax line that sets the safe harbor
- Every 1099-R and the SSA-1099, each showing federal (and Colorado) withholding
- A list of estimated payments made, with dates and amounts, federal and Colorado; the IRS sends no statement
- Any penalty notice received, so the computation can be checked and the fix applied
- For a fall checkup: year-to-date pension, IRA and Social Security statements, and the amount of any RMD still to be taken in December
- If a one-time event is coming: the amount and the month, so the safe harbor can be set and the event’s tax set aside
Questions people ask
I always owe in April. Is that a problem?
Only if the amount paid in during the year misses both safe harbors. Owing $900 with no penalty is fine, and arguably better than a refund. Owing $9,000 with a penalty means the withholding needs resetting.
I had a big Roth conversion this year. Do I have to make estimated payments?
Not if your withholding already covers 100% (or 110%) of last year’s tax. Then the tax on the conversion is simply due April 15. Otherwise, either withhold on the conversion itself or make an estimated payment for the quarter the conversion happened.
Can I pay the whole year’s estimate in January instead of quarterly?
Not without a penalty for the first three quarters; estimates are credited when paid. Withholding is the exception: tax withheld in December counts as if paid evenly all year.
How big is the penalty?
It is an interest charge, at the IRS rate (about 7% a year recently; verify), on each quarter’s shortfall from its due date to April 15 or when paid. A $4,000 shortfall spread across the year costs roughly $150. Annoying rather than ruinous, but avoidable.
Does Colorado charge a penalty too?
Yes, on the same logic. It is smaller because the rate is 4.40%, and it is avoided the same way: a Colorado withholding election with the payer, or Colorado estimates through Revenue Online.
The “last year’s tax” test is the useful one
Pay in 100% (or 110%) of last year’s total tax through withholding and estimates and there is no penalty, whatever this year brings. It is a number you can read off last year’s return in January, and most of it can be withheld rather than mailed.
Forms and official pages named in this article
- Form 1040-ES, Estimated Tax for Individuals (vouchers and worksheet)
- IRS Direct Pay (make an estimated payment online, no fee)
- Form W-4P, Withholding Certificate for Periodic Pension or Annuity Payments
- Form W-4V, Voluntary Withholding Request (Social Security)
- Form W-4R, Withholding Certificate for Nonperiodic Payments (IRA withdrawals)
- Form 2210, Underpayment of Estimated Tax (the penalty, and the annualized method)
- Colorado Form DR 0104EP, Estimated Tax Payment Voucher (verify) and Revenue Online