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IRS pension paperwork a head-spinner

Dear Tax Talk,

I have begun filling out the paperwork to begin pension payments from my old company. Everything was going swimmingly until I hit the W-4P, the form used to establish withholding for pension payments. Typically, the IRS has taken what would seem to be a simple question and turned it into a labyrinth.

I did OK on the part about figuring out exemptions, I think, but the second page threw me for a loop. For one thing, it asks for "an estimate of your 2005 itemized deductions." It's July! I have no idea what my deductions for the entire year will be. Or even if I will use itemized deductions!

It also asks for an estimate of my 2005 "adjustments to income." Again, it's July! Who knows? I'm also confused by the section about "Multiple pensions/More than one income worksheet." Since I'm still employed by another company, I guess that applies to me, too. It's also a maze and I can't figure out why it's necessary.

Any help you can give me here on determining how withholding is figured on pension payments would be greatly appreciated. -- Desperate Doug

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Dear Doug,
I sense your pain. Form W-4P is used by a pension plan administrator to figure the amount of tax to be withheld from periodic pension payments. It works much the same way a Form W-4 does for salaries. In fact, the tax withholding is based on the same tables as those used for wage withholding found in Circular E.

You can also elect to not have any tax withheld or to have a fixed-dollar amount of tax withheld. However, you cannot have the fixed-dollar amount withheld without entering the number of allowances on line 2 of the form. The personal allowances worksheet may be enough to make your head spin, but the other two will make you tear your hair out.

The deductions and adjustments worksheet adds to the number of allowances you can claim. Each $3,200 in expected deductions and adjustments is worth one personal allowance. Rather than try to guess at your 2005 deductions, use the amounts from your 2004 tax return. They are probably similar year to year. The other worksheet, apparently developed by Al-Qaeda operatives working within the Internal Revenue Service, is used to figure a flat amount to be withheld from your pension based on your other income.

Since tax rates are percentages of income, I am not sure why the IRS does not simply allow you to express the withholding as a percentage of the pension payment. It can't be that they figure we're too dumb to get the right percentage, but yet smart enough to figure out the worksheets. It may be that they want retirees to have something to do in retirement.

My recommendation to you, and a general rule, is to enter the same number of allowances as on your employment W-4 and see how much tax is being withheld (or ask the pension administrator for this information). If the withholding is less than your marginal tax rate, then I would use the difference as the flat amount to be withheld from each payment.

Your marginal tax rate is the percentage of tax that the next dollar you make will be taxed at, based on the 2005 tax rate schedules. It will be 15 percent, 25 percent, 28 percent, 33 percent or 35 percent. Figure out which percentage to use based on your current expected taxable income before counting the pension payment or based on your 2004 taxable income (Line 42) if it is expected to be the same.

For example, assume you claim zero allowances at work and will receive $1,000 a month in pension-plan payments, you're married and your 2004 taxable income without the pension was $140,000. Based on the Circular E table on page 52, your $1,000 monthly pension should have $35 in federal income tax withheld. Based on the tax rate schedules for 2005, your $140,000 in taxable income puts you in the 28 percent bracket. So $280 in tax should be withheld. You should enter the difference between $280 and $35 or $245 on line 3 of form W-4P. With the time saved in completing Form W-4P, you should write your congressman.

Bankrate.com's corrections policy
-- Posted: July 13, 2005
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