Taxes are never fun to pay, but you must figure out a way to pay them. You may not have a choice when it comes to pension income. However, when you are given the option to have taxes withheld, the decision may not be clear-cut. You should weigh the benefits and disadvantages of having taxes withheld.
Pension and annuity income is normally subject to withholding. This means you will have money withheld from your paycheck prior to receiving anything. The amount withheld may be changed to more closely reflect the amount of adjusted gross income you expect to receive during the year. You must use Internal Revenue Service Form W-4P for pension income.
By lowering your withholding, you increase your income. You will have more money to spend during the year. You'll also receive less in return when you file your tax return. You can also invest some portion of the amount you receive as a result of the lowered withholding amount to earn interest on your pension income. If you do end up owing tax, then you'll have made money during the year before having to give it to the government.
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You may seriously underestimate the tax you owe. If you spend more money than what you owe in taxes, then you'll be left with a shortfall at the end of the year. You won't be able to pay your tax. You may end up with severe penalties and fees for paying late in addition to interest on both the tax you owe as well as the penalties assessed.
Consider using the IRS withholding calculator (see Resources). This calculator will help you accurately adjust your withholding so that the right amount of money is withheld from your pension check each month. This will prevent you from giving the government excess amounts for the payment of tax without the ability to earn interest on that money during the year. Likewise, it will prevent you from having to come up with money you don't have to pay a large tax bill at the end of the year.
- "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, et al.; 2007
- IRS: Pension and Annuity Income