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Retirees: Is Your Tax Refund Costing You Money?

Millions of people get tax refunds every year and, according to the IRS, the average refund this year is $1,949.  Much has been said about how a large tax refund is just an interest-free loan to the government and people should adjust their withholdings to keep more of their money in their pocket.

That topic has been well covered and so I won’t beat it to death any further.  But for retirees, there is another interesting angle when it comes to tax refunds.  A big tax refund may actually be costing you real money.

Let me explain; the tax code is built on a system of complex calculations for different types of income.  Long-term capital gains being taxed differently than wages is just one example.  For retirees, by far the most impactful is how your Social Security is taxed.  Basically, 50% of your total Social Security benefits, plus your other income, determines how much of your Social Security is taxable.

This is where the potential problem starts.  Let’s use an example to play this out:

Linda is single, 64 years old and needs $4,300 per month to live in retirement.  She gets $20,000 a year, or $1,666 a month, from Social Security.  She needs to take a net $2,634 monthly from her traditional IRA to make up the shortfall.  She also wants to have taxes withheld on her IRA withdrawals to cover the tax bill, so she withholds 20% on top.  This makes her gross withdrawal from her IRA $3,292 a month or $39,504 a year.

When we use these numbers to determine her Federal tax owed, assuming she uses the standard deduction, her total Federal tax bill is $5,735.  Fortunately, or maybe not, she had $7,900 withheld from her IRA withdrawals to cover the taxes ($39,504 X .20).  This net result is she gets a refund of $2,165.

While it might feel good to get an “extra” $2,165 back at tax time, this is no doubt a terrible result for Linda.  If she had had the proper amount of tax withheld she would have actually caused her total tax bill to go down.  Suppose she only had $5,735 withheld from her IRA withdrawals, instead of $7,900.  You would think she would have neither owed money or received a refund right?

By making the tax withholding adjustment, her total tax bill actually drops to $4,998, saving her $737.  How is that possible?

This result stems from the underlying calculation of how Social Security and pre-tax IRAs are taxed.  There are two tax benefits from Linda lowering her tax withholding:

1) She has less taken out from her IRA in total.

Remember, in the previous example, her total yearly withdrawal was $39,504 ($3,292 per month X 12 months).  After the tax withholding change, the total yearly withdrawal is now $37,339.  Linda still gets the same amount of net money each month, she simply has less withheld in tax, which lowers her total yearly withdrawal.  This effectively means she is not paying tax on the extra money she was withholding just to cover the taxes!

2) Less of her Social Security will be taxable because her total income is lower. 

In the first example, a full 85% of her Social Security was taxable, or $17,000.  But after the tax withholding change, only $15,838 of her Social Security was taxable.  Lowering her tax withholding not only lowered how much IRA income she has to pay tax on, but also lowered how much Social Security is taxed.

There can be additional benefits to lowering the tax withholding as well.  Linda might be able to itemize more of her medical expenses now that she has lower adjusted gross income (AGI).  Also, because Linda is taking lower total yearly withdrawals from her IRA that keeps more of money to work in the investment markets.

It can pay serious dividends to review your tax return closely at this time of the year.  Learning how the tax code works, or working with an expert, can result in serious savings with even minor adjustments.

Steven Elwell, CFP®
Partner, Chief Investment Officer

Steven Elwell
Steven Elwell