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Witholding Taxes On Retirement Distributions


Witholding Taxes On Retirement Distributions

When a taxpayer gets a retirement distribution and tells the broker to, “withhold taxes,” they think they have done the right thing and now they are covered. Well, they usually aren’t!

In my experience the default for withholding taxes from retirement distributions is usually 10%. The 10% tax bracket ends at $9,225 of taxable income for a single person, and $18,450 for married filing jointly, so the tax charge will usually be more. If you are going to make a withdrawal from your retirement account, you should figure out what tax bracket you are in, and have them withhold at that rate. In addition, if you are under 59 ½ at the time of the distribution, you may be assessed a 10% penalty because it is an early distribution. There are some exceptions to this, which should be researched, but more often than not, the penalty will show up on your tax return. One piece of good news, however, is that if you are an Illinois resident taking a qualified retirement plan or IRA withdrawal, it is free of Illinois tax, whether the distribution is premature, or not.

So, how do you figure out how much money you need to take out, if you want to withhold appropriate taxes, and still get the amount you need? First, consult with your accountant as to your marginal tax rate (the rate of tax on the next dollar added to income), then divide the needed amount by the reciprocal (1 less the tax rate percentage, expressed as a decimal) of the tax rate to get the gross dollars you must distribute. Don’t forget to add 10% to the tax rate, if this will be considered a premature distribution and no exception to the penalty applies. For example, if you were in the 25% tax bracket and were under age 59 ½, and didn’t qualify for an exception to the penalty, and you wanted to take out $10,000 to pay a bill. You would need a distribution of $15,385 to pay the required 35% in federal taxes and penalties (25% tax bracket, plus 10% penalty) to net the $10,000 you want. The formula looks like this 10,000 / (1-.35) to get the $15,385. 35% of this amount is $5,385 for taxes, leaving you with the desired $10,000.

So next time you want to take money out of your retirement account, first consider what may be a high tax cost, then make sure the appropriate amount is being withheld at the source, so no major surprises await you the next April 15th!