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Avoid retirement tax shocks

By Jennie L. Phipps ·
Sunday, January 2, 2011
Posted: 10 am ET

A reader of this blog, who also works with the AARP Tax-Aide program, points out that January is the time to make sure that you are going to have money available to pay not only this year's taxes, but also next year's. It's a retirement planning basic.

The AARP program offers free tax assistance to low- and middle-income taxpayers with relatively simple tax-filing issues. The program is available nationwide at 6,500 locations nationwide in senior centers, libraries, community centers and similar convenient locations. If you paid to have a simple filing done for you last year, consider using the AARP program this year.

Failure to properly withhold is an issue that tax experts working with this program encounter frequently. A big shocker for many people in retirement is the tax bill they face from taking money out of their IRAs or 401(k)s. Our reader says,"It's usually someone who needs the money because they encountered an unexpected expense. They take the money out, spend it, and then at tax time have a big bill."

For instance, if you are in the 20 percent tax bracket and you take $10,000 out of your IRA, you could owe $2,000 -- $3,000 if you are younger than 59½ and have to pay a penalty for taking the money prematurely. That's a big chunk of cash if you're not prepared. The best way to handle it, our tax expert says, is to set up withholding at the time you do the withdrawal or increase withholding from your Social Security over the course of the year enough to cover the bill by the end of the year. That way you won't come up short.

Another withholding issue that our reader points out is an opposite problem. He says that if you have a very part-time job that augments your Social Security and very little income otherwise, tell your employer not to withhold at all. You are unlikely to owe anything at tax time and you'll have to file to get the money back.  Not withholding in the first place will put a little more spending money in your pocket.

Finally, if you are older than 70½ and must take required minimum distributions, or RMDs, from your IRA or other tax-advantaged accounts, now's the time to make a plan and work it. If you don't need the money, you might as well hold onto it until the end of the year. But if are relying on the income, set up regular withdrawals now as well as regular withholding. Our tax expert friend says he often encounters first-timers to the RMD requirement who don't manage it well and are faced with a tax surprise.

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