The Estimated Tax Penalty Retirees Pay Even After Paying in Full

Many retirees think that if they pay their full tax bill by April 15, they did everything right. That is not always true. The IRS can charge a penalty when you pay tax late in the year, even if you pay the full amount. The rate is 7% a year right now. A change you make before December 31 can often fix the problem.

You filed your tax return. You paid every dollar you owed. A few weeks later, a letter from the IRS arrives. It says you owe a penalty anyway. For many new retirees, this is the first IRS penalty they have ever received. It does not seem fair, because they paid the bill in full.

The problem is timing. The IRS wants you to pay tax during the year, as you receive income. When you worked, your employer took tax out of each paycheck. This is called withholding. You did not have to think about it. In retirement, you must set it up yourself. Social Security withholds nothing unless you ask. IRA withdrawals usually have 10% withheld, and you can choose to have nothing withheld. Pension withholding is often less than you will owe.

The friend to send this to: someone who retired this year and plans to "settle up with the IRS in April." Send it before December 31, while there is still time to fix the problem.

The IRS uses a "pay as you go" system. You must pay tax during the year, close to when you receive the income. This rule applies to paychecks. It also applies to IRA withdrawals, pensions, and Social Security.

Here is an example. You take $40,000 from your IRA in March. You choose no withholding. Next April, you pay all the tax you owe, and your balance is zero. The IRS can still charge a penalty. The tax was due during the year, not the next April.

You do not owe the penalty if one of these is true:

Timing also matters. The IRS divides the year into four periods. The due dates are April 15, June 15, September 15, and January 15. You must pay about one quarter of the total by each date.

The penalty is like interest on a loan. The IRS charges it on the money you did not pay on time. The rate is the federal short-term rate plus 3 percentage points. The IRS sets a new rate every three months. The rate is 7% a year now.

The IRS charges for each day the money was late. A full payment later does not cancel the charge for earlier months. For example, you are $10,000 short from April 15 to January 15. The penalty is about $525.

An estimated payment counts only on the date you send it. Withholding is different. The IRS treats withholding as if you paid it in four equal parts during the year. This is true even if the withholding occurs in December.

So December is not too late. Suppose you take an IRA withdrawal in December and have a large amount withheld. The IRS counts one quarter of that withholding as paid in April. This can remove the penalty for earlier months. An estimated payment in December cannot do this.

Be careful with the amount. An IRA withdrawal is taxable income. If you must take a required minimum distribution (RMD) this year, that is the easiest place to add withholding.

The IRS can cancel the penalty in some cases. You may qualify if you retired after age 62, or became disabled, this year or last year. You must also show that the underpayment had a reasonable cause. You ask for this waiver on Form 2210. The IRS does not give it automatically.

You do not need to guess next year's income. You do not need to send four checks a year. One change to your withholding can often fix the problem. Check it again each year, because your income can change.