Making the Most of the Tax-Filing Extension

Most retirees have Social Security income and many others have additional income sources, including investments and required minimum distributions from tax-sheltered accounts. Some people may also have pensions or continue to work part-time in retirement.

With multiple lines of income, retirees may need to work closely with both their financial advisors and their accountants to navigate tax payments, especially if they receive income from alternative investments, like hedge funds or partnerships, which may not issue tax forms until well past the traditional April 15 tax deadline.

For people about to retire or the newly retired, Craig Bolanos, CEO of Wealth Management Group LLC, urges his clients to meet with tax specialists to deal with the nuances of transitioning into retirement.

“I tell everybody, your action item going into retirement: you’re going to find a CPA strategist,” he says. “This is non-negotiable.”

A CPA strategist will review all of the new retiree’s income sources to maximize income while minimizing tax bite. “This person is going to strategize for you your withholding game plan to ensure that you don’t run into the buzz saw of excess taxation on your social security, Medicare means-testing and other issues,” Bolanos says.

Sources interviewed agree that the easiest way to avoid underpaying taxes is to have income withheld. However, some retirees would rather estimate quarterly payments to avoid both underpaying and overpaying taxes.

Refunds aren’t common for retirees, but it happens. Bolanos gives a few reasons why. Employment income may have changed because someone worked only part of the year. A retiree might have taken big investment losses on 2018’s return filed in 2019. Or the retiree may have had too much money withheld on the 1099 distribution from their IRA, 401(k) or annuity.

He prefers that retirees don’t receive refunds, since it can affect some means-testing benefits for social security and Medicare that kick in at certain thresholds. Retirees should consider applying refunds to next year’s taxes, especially if they’re expecting a larger tax bill.

“If we’re going to owe more money, it’s going to force us again to take more money out and put more taxable income on return,” he says.

If retirees get a refund, it isn’t considered income and won’t affect future taxes, says Dean Borland, senior vice president at FineMark National Bank & Trust.

Tax underpayment is a bigger worry for retirees, since underpayment can result in penalties and interest charges which can pinch cash flow. The amount of penalties varies by the size of the underpayment, but Naomi Ganoe, CPA, managing director and private client service practice leader at CBIZ MHM says penalties don’t kick in until the underpayment is more than $1,000.

To use 2020 as an example, to avoid paying penalties when paying taxes quarterly, retirees need to estimate their likely entire 2020 tax liabilities and pay 90% of it over the four tax quarters, Ganoe says. They can also base their 2020 taxes on the prior year income tax, using what’s called a safe harbor estimate. That calculates to 100% of the prior year income tax as long as their adjusted gross income is under $150,000. If it’s more than $150,000, then it’s 110% of the prior year tax.

However, Ganoe points out that tax bills in 2019 might be higher because of last year’s strong market returns, which means more capital gains and investment income. But come next year, people will not want to use 2019 for their tax liability because it will be higher than 2020 because of the market selloff.

To avoid tax under or overpayment for clients who estimate taxes and have multiple income sources, Ganoe says she’ll look at their tax returns for a holistic view and they work with the investment advisor about calculating tax payments.

“We will say to the investment advisor that for every dollar of RMD that (their client) has, because sometimes people take more distributions than they’re required, then you should withhold a percentage of federal and a percentage of state taxes,” she says.

Ganoe says retirees need to pay taxes in the quarter when they receive the income, but that tax payments can be annualized if their RMDs come in the fourth quarter.

“If they’re mainly taking social security all year long and a little investment income, they probably have no estimated (tax) needed until the fourth quarter if they’re taking their RMD in the fourth quarter,” she says.

One of the benefits of using RMD withholding is that the IRS treats withholding as if it happened randomly throughout the year, so it helps to avoid any penalties. “The IRS assumes that you paid it equally throughout the whole year, even though you didn’t pay it till December of the end of the year,” she says.

RMDs are useful to avoid underpayments, too. “People often use the RMD to catch up for other withholding as needed for the other buckets of income, because again, withholdings are treated very favorably by the IRS.”

Sometimes underpayments are unavoidable when retirees have alternative investments, as they don’t receive the tax forms needed to complete their annual taxes. They can file for an extension, but any taxes normally must be paid in April; however, that will be extended this year. Retirees can do their best to estimate taxes, but it may only go so far, he says.

For wealthy retirees who have sizable investments in alternatives, this can be a very big challenge, Borland adds. Penalty-proofing gets taxpayers through the annual tax filing deadline, but CPAs and tax preparers had to make a best guess on what the alternative investments might provide as taxable income, and sometimes, it can mean they owe more. So retirees are best to brace for underpayments.

“When you finally prepare your return after you’ve gathered all of your information, your K-1s, if you paid $100,000, but you owe $125,000, they’re going to charge you penalties and interest on the $25,000 underpayment,” he says.