Retiring from the military can be a wonderful time of life, but it is also a time of uncertainty, about jobs, residence, moving and other significant changes. Once all these are settled, retirement can seem like everything you dreamed it could be - until that first tax return. I've prepared dozens of newly retired military tax returns, and not one has had a happy outcome. I'll grant that some people are ready for it, but most times they are not. I've seen reactions that vary from, "That's all I'm getting back?", to, "I owe $5000?", to, "$25000! are you f**ken kidding me!" It would not be an exaggeration to say that the several thousand dollar balance due is the most common result.
With this post I hope to provide information to mitigate the effects of retirement on your taxes (you can't prevent taxes, only minimize and prepare). I'll start by explaining the changes you'll see, and then talk about what you can do.
ALL your income is taxable now. That's right, no non taxable allowances, combat pay or other bene's. You might have the same salary as when you were on active duty, but at least 20 to 30% more will be taxable. While in the military, this had the effect of keeping most of your income out of the 25% tax bracket. To dispel a common misconception, only the portion of income that is in the 25% tax bracket is taxed at 25%, the rest at lower tax rates, but we'll see why this matters as we discuss things in more detail...
Your new job doesn't know about your retirement income, and your retirement income doesn't know about your job. This means that your wages and retirement will under withhold in almost all circumstances. For an example, let's say you're married with two kids. You put Married 4 on your W-4 form, and, while on active duty, this would be fine. Now however, your job might put you a little into the 25% tax bracket, so they withhold just a little more than 15%. Your retirement sees you in the 10 to 15% tax bracket, so they withhold just over 10%. Together, they you're thoroughly into the 25% tax bracket. If you make $20000 more than the bottom of the 25% tax bracket, that's $5000 that should be withheld but maybe $3000 actually gets withheld. Those numbers add up! This also is made worse if your spouse works.
Did you get a great relocation package? They may have even covered the taxes for you (much of the package is taxable income.) The problem is that the relocation package drove you right THROUGH the 25% tax bracket and into the 28% tax bracket. Your retirement should be taxed at 25% but they're withholding 15%. Say you get $40000 in retirement. The withholding will be less than $6000, but you should have $10000 withheld. Do the math: $10000 - $6000 = My tax bill is how much?!?
What happened to my $1000 Child Tax Credit? What about my Education Credit? And just what the hell is the Alternative Minimum Tax? Military allowances tend to keep you from the income limitations that many people face. If you have a kid in college, you could get a $2500 American Opportunity Credit. If you have kids under 17, you should get $1000 each on your taxes, but both of those have income limitations that you might face at your new income. The Alternative Minimum Tax is a tax designed to make everyone pay their fair share, but more and more people face it every year. A detailed analysis is beyond the scope of this post, but let’s just say this - it's BAD.
Wait, State taxes? I never paid them before. I know a lot of you are "residents" of tax free states, or are from states that don't tax military, but now, you reside where you work. Most of those states are going to want their share of your money. DFAS tends to not withhold state taxes unless you make them (though many states don't tax military retirement). You should talk to your tax guy about the specifics of your state.
What do you mean I owe? They withheld the tax on my Thrift Savings Plan early distribution. DON'T DO IT - IT's A TRAP! Seriously, unless you’re over 55 and not planning on working LEAVE IT ALONE! Now is not the time to get clever about using it to buy a house and not having a payment. Here's the deal: They will withhold 20%. 10% of this will cover the early withdrawal penalty. That leaves 10% in taxes. I believe we covered your new tax rate above (hint - at least 25%.) That means you are AT LEAST 15% under withheld. Take too much out and you could be a s**t ton more under withheld. Think - "I'm going to OWE at least $1500 for every $10000 taken out (not counting the $2000 they already kept.)" That means, ignoring state taxes, you get less than $6500 of every $10000 you take out. I don't care what the interest rate on your house would be - you're not making that back! DON'T DO IT!!!!!
What to do:
So, besides not taking money out of your Thrift Savings Plan, what do you do? You have several options:
1: Over withhold from your pension and your job
2: Make estimated tax payments (I’m not a big fan of this one.)
3: Save a large amount of money in the event that you have a large balance due
4: Do a combination of the first three (another is ignore and hope, but I can tell you that doesn't work).
You should continue to treat taxes very conservatively until at least the end of your first full retired year. Also, no matter which method you use, you should ensure that your withholding and/or estimated tax payments at least equal your tax liability from the previous year. This will ensure you don't owe a penalty for underpayment.
To increase your withholding, you submit a W4 form. The IRS likes to pretend that if you follow the instructions, everything will be fine. This is bunk. The W4 instructions are the most useless instructions of any IRS form. My advice is to simply select Single and 0 for each and every job you have, as well as your retirement (you can do this online via Mypay for retirement.) After your first full year of retirement, if you get a big refund, you can readjust your withholding. I must warn you though; even this might not be enough. You should strongly consider having a very conservative budget until you are sure what your tax situation will be. Set aside lots of money just in case you owe.
My best advice is to call your tax guy after you start the new job. Give him or her detailed information about your new income (retiree statement and pay stubs are best) and he/she can run the numbers for you.
Feel free to contact me with questions at: firstname.lastname@example.org