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Retired Military Finances 101: I Got a Refund on My Taxes, but the IRS Penalized Me for Under-Withholding. What's Up?

Taxes

After retiring from the military it can be challenging to get your withholding correct (read about it here). The withholding forms and tables were designed for a family (or individual) with a single bread winner. If you retired as a Senior Military Officer or NCO, that probably doesn't fit you. You'll have your pension as one source of income and your new job as a second. That sets you up to owe taxes when you file and if you owe taxes you might get penalized for under-withholding. Here' is how that works.

When the Under-Withholding Penalty Normally Applies

If you owe taxes when you file you may owe a penalty. You apply 3 tests to see if you owe or not.

  1.  If you owe less than $1,000, under-withholding penalties do not apply
  2.  If you withheld 90% of your current year's tax obligation, you won't get penalized for under-withholding
  3. If you withheld 100% of your prior year's tax obligation (110% if your prior year's AGI exceeded $150,000), you're off the hook and won't owe a penalty

But...things are never that simple with the IRS

Taxes Are Due When You Earn Income

Let's say you've retired from the military, it's your first full year in retirement and you're working for a defense contractor. Your income is pretty much even throughout the year. In December, your buddy from work, who is also a military retiree, tells you about how he got killed when he filed his taxes. He owed close to $10,000. You decide to figure out how much taxes you'll owe. You do the math (complete a Form 1040-ES, as one way), and determine you'll owe about $12,000. Just to be safe, you make an estimated payment of $13,000 in December.

You file your tax return on 15 Apr and you were right, you did need to pay an additional $12,000 in Federal Income Tax. Since you made a payment of $13,000, you'll get a refund. But, it won't be $1,000. It will be some amount less than that. That is because you'll owe an under-withholding penalty. How's that?

Most people think their taxes are due on 15 Apr. In reality, you owe the taxes as you earn the money and you're only reconciling the amount withheld against the amount owed when you file your taxes. In the IRS' mind, you should have withheld an additional $1,000 per month and you under-withheld. Hence the penalty.

What to Do?

If you find yourself in this situation, it is much better to fix the problem through increased withholding instead of making a large estimated payment. In the case of withholding, the IRS assumes your withholding was done evenly throughout the day. If they want to assume that, let them.

By the way, if your income isn't even (large bonus or capital gains late during the year) estimated payments to cover that income is o.k. Just make sure you pay it for the quarter in which it is earned.

Military Finances are Different

Your finances and taxes are as different from a civilian's as your military career was as different as a civilian's career. That's why we think you should work with a financial advisor or planner that deals with those differences every day. If you'd like to chat about how we do that, click on the button below to schedule a free initial consultation or give us a call.


If you found this article useful, you might like the following blog posts:

Military Retirement, VA Disability and Your Taxes


Bigger Tax Refund Than Expected?


6 Ways the Tax Cuts and Jobs Act Affects Retiring Military Officers



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