Retired Military Officers Get Surprised When Filing Their Taxes for the First Full Year of Retirement
I see them every year. They come into my office just a little bit bewildered about the fact that after 27 years of getting a refund when they file their taxes they now have to stroke a check to the IRS to the tune of $5,000 - $6,000. They used the same number of allowances on their W-4 that they've always used. What went wrong?
Multiple Sources of Income Cause Multiple Tax Issues
Our tax system is progressive. That means that as your taxable income goes up the tax rate you pay goes up. What is important to understand is that the rate goes up on the "next" dollar earned. This is called your marginal tax rate.
Let me explain. The first dollar you earn literally has a tax rate of 0%. The $122,000th dollar of taxable income has a tax rate of 22%. This is what causes the problem.
Since you are retired from the military, you have two or more entities (DFAS and your employer) who think the first dollar they pay you is the first dollar you've earned and they don't withhold any taxes from it. In reality, one of them should probably withhold taxes of at least 12% on that first dollar earned. The following chart shows what I mean. The line on the second pay chart shows that the first dollar paid by the civilian employer should be withheld at 12% and some at 22%.
How Do You Fix the Under-Withholding Problem?
The best thing to do is to complete a Form 1040-ES and make sure that your withholding is accurate. Then go into MyPay and have an additional dollar amount withheld from your retired pay to make sure any deficit is taken care of. Don't mess around with changing allowances. It is too inaccurate. And don't forget state income taxes as well, even though the problem isn't as pronounced with them.
If a 1040-ES isn't in your future, then at least take the time to accurately complete your Form W-4. And if that is too much, then make sure your withholding is around at least $1,500 per month (assuming income of around $150,000) from all sources combined.
I've found that a lot of military officers, both retired and active, are unaware that if you under-withhold your taxes, you can be subject to penalty (some waivers apply). That's giving free money to Uncle.
Transitioning to the Civilian Sector Isn't Easy
Transition challenges exist regardless of when you leave the military. They're different for a one-term servicemember than they are for a senior military officer with 20 plus years of service. But in both cases, it is better to face them with support. In the financial realm you'll want to work with someone who knows the unique challenges facing transitioning senior military officers and the benefits available to you.
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