Why you should check your pension tax withholding every January

A pension is taxable income. The tax is not deducted automatically at the right rate, because nobody at the plan knows what else you have coming in, and the amount they hold back is whatever you told them to hold back, possibly years ago.

January is the month to look at it, and it takes about twenty minutes.

Why it drifts

Your circumstances move and the withholding does not.

You claim Social Security partway through a year. You start taking required minimum distributions at 73. Your spouse retires. A part time job ends. Interest rates rise and the interest on your savings doubles. Each of those changes your total taxable income, and none of them tells your pension administrator anything.

Then there is the annual cost of living increase, where it applies, nudging the gross up a little each year.

Two years of small drift is how people end up owing four figures in April and being genuinely surprised by it.

The Social Security part people miss

Up to eighty-five percent of your Social Security benefit can be taxable, depending on your combined income. Plenty of retirees do not realise their Social Security is taxable at all, and they certainly do not realise that a pension is part of what pushes it over the line.

That is the mechanism behind most of the nasty April surprises I have heard about. Not the pension itself. The pension dragging the Social Security into tax.

If you want tax taken out of the Social Security payment itself, that is a separate form, W-4V, and the choices are fixed percentages rather than a dollar amount.

The form for the pension

Form W-4P. It was redesigned a few years ago and it no longer uses allowances, which is the source of a lot of confusion for anyone who has not looked at one since.

You can either work through the steps for multiple income sources, or use the extra withholding line to add a flat dollar amount to each payment. For most retirees with a predictable income, the flat extra amount is simpler and easier to get right.

Do not overlook state tax. Some states have their own form, some do not tax pension income at all, and a few tax part of it. Check what your state does rather than assuming, particularly if you have moved since you retired.

Getting the number right

The IRS has a withholding estimator on irs.gov. It is better than it used to be and it is free.

The cruder method works too. Take last year's tax return, add up what you expect to receive this year from every source, and compare the total tax you paid last year against what is currently being withheld across all your income. If the withheld amount is well short, divide the gap by twelve and put that on the extra withholding line.

Aim to be slightly over rather than slightly under. A refund is an interest free loan to the government, which irritates me on principle, but it is better than a penalty.

The penalty, briefly

The IRS expects tax to be paid across the year, not settled in April. Underpay by enough and there is a penalty on top of the tax.

There are safe harbours that protect you, generally based on paying at least a set proportion of last year's tax or of this year's. If your income is steady, meeting the safe harbour is not difficult once you know it exists.

One useful quirk: tax withheld from a pension is treated as paid evenly across the year no matter when it was actually withheld. So if you find in November that you are short, increasing the withholding on the last two payments can fix the whole year in a way that a lump sum estimated payment in November cannot.

Make it a habit

Put it in the diary for the second week of January, when the 1099-R forms have arrived and you can see what actually happened last year.

Pull up the statement, look at the gross, look at the federal and state withholding, compare against your return. Adjust if it has moved.

I do mine with the 1099-R on the table and the previous year's return next to it. Twenty minutes, once a year, and I have not had an unpleasant April since 2020. Before that I had two, and both were entirely my own fault for not looking.