Hello PYFR team! I love the podcast and appreciate it and all the resources you offer. My question is about taxes on the pay-out of annual leave for retirees. I assumed it would be considered income just like salary and would be taxed at whatever rate my income met for that year. But, a colleague who is planning to retire in a few months is planning to use all his leave now because he thinks the payout will be treated like a bonus and taxed at a higher rate. And, are bonuses even taxed a higher rate, or is only the amount withheld higher? Thanks so much! – Kevin
Have you ever wondered if you should burn your annual leave or save it as a lump sum? Which option will be taxed higher?
Understanding the Tax Implications of Annual Leave Payouts
Let’s delve into the factors that might lead you to believe that the payout is taxed at a higher rate, and understand the reality behind it. This knowledge will empower you to make informed decisions about your annual leave.
Bonuses are not taxed at a higher rate. This also applies to your annual leave payout. The amount of tax you pay is based on the total amount of income you’ve earned. With our progressive tax system, the more income you make, the more you pay in taxes. Not just in tax dollars but your marginal tax rate, the percentage of tax applied to your income, can also increase.
Timing of Income and Tax Withholding
Why do people think bonuses are taxed at a higher rate? It has to do with income timing. Most people retire at the end of the year, saving up all their leave to get a big cash-out payout in January. When this payout happens, taxes are withheld based on the IRS’s Circular E, which employers use to calculate tax withholdings.
When you receive that large payout in January, the system assumes this is your regular paycheck amount for the entire year and withholds taxes accordingly. This leads to a larger amount being withheld, making it seem like the payout is taxed at a higher rate. However, this is just the estimated withholding amount. Depending on your total income and withholdings for the year, you may get some of that money back as a refund when you file your taxes.
Multiple Income Sources and Tax Implications
Retirees often have multiple income sources, such as pensions, Social Security, and TSP withdrawals. Each of these sources assumes that it’s your only source of income, leading to too little being withheld overall, and retirees might owe more taxes at the end of the year. The annual leave payout is a rare exception where a higher amount is withheld initially due to the Circular E guidelines.
A Quick Tax Hack
If you find yourself in this situation and want to avoid overpaying in taxes, you can always adjust your W-4 to withhold less in taxes from your annual leave payout. Do this in December before you receive the check. However, be careful not to underpay the IRS, as they can impose penalties.
Personalized Advice
If you have further questions about taxes in retirement, remember, you’re not alone. It’s essential to consult with experts who can provide personalized advice tailored to your specific situation. Schedule an appointment with us at Plan Your Federal Retirement. Our advisors are here to ensure you receive the best guidance possible, supporting you every step of the way.
Micah Shilanski 00:02
Have you ever wondered if you should burn your annual leave or if you should save it as a lump sum? Which one is going to be taxed higher? If you ever wondered the answer to that question then stay tuned for this FERS Federal Fact Check. Hi, I’m Micah Shilanski with Plan Your Federal Retirement. And we have a great question that has come in today from Kevin. This is talking about taxes, which you all know I love to talk about, not only taxes, but going to be your annual leave and what you should do. Hello, PYFR team. I love the podcast and appreciate all the resources that you offer. My question is about taxes on the payout of annual leave for retirees. I assumed it would be considered income, just like salary, and it would be taxed at whatever rate my income, for me would be that year. But a colleague who is planning on retiring in a few months, is planning to use all of his leave now because he thinks he’ll be taxed at a higher rate, bonuses are taxed at a higher rate. Are bonuses taxed at a higher rate, or is the amount withheld higher? Thanks so much. Kevin, that is a great question, and you are correct in your assumption, but there’s some things that happen which makes people thinks it’s going to be taxed higher. So let’s walk through this. The answer to the question is no. Bonuses are not taxed at a higher rate because you’re getting a bonus, or an annual leave payout. It’s all based on the total amount of income that you’ve earned, right? We have this progressive tax system, the more income that you make, more you’re paying in taxes, not just in dollars, but in percent as well. That’s going to come in. So once you retire at the end of that year, how much income you make, that’s going to be one indication that indicated how much taxes that you have to pay. There’s ways you can control that, that’s for a different question. All right, so let’s talk about why do people think bonuses are taxed at a higher rate? And it has to with when they’re getting this income. So what happens when retirees, when you, most people, retire at the end of the year, so they save up all of their leave, right? They had their full forward leave, plus they’re saving up everything for the year, and they get this big cash out, big carry forward, right? Then they have this big cash out, which is going to come this next year. But when they get that cash out, what happens that gets paid out in January. And the way taxes are withheld is that w4 that you have to fill out on how much taxes you’re withheld from your paycheck. But the way that it works is this thing called a circular E. It’s on the IRS code of how employers are supposed to calculate this. And what they do is you get this large payout in January, and they’re like, Wow, this is going to be Kevin’s normal check for the rest of the year, we have to withhold more taxes. So they don’t look at it and say, Oh, this is his last check, therefore we should withhold the same amount. They look at it just in the computer system where they’re supposed to that says he is going to keep getting this. So they withhold a large amount of taxes on that annual leave check that you get. So people look at it says, Oh, my gosh, this is taxed at a higher rate, not taxed at a higher rate. It was withheld at a higher rate. But you don’t owe that. You might end up getting that money back. It really depends on where you shake out for the year. One of the things we talk about taxes, and Kevin, I’m sure you’ve heard before, is one of the confusing parts for retirees is you have income coming in from multiple sources. When you have this income coming in from multiple sources, what that means is not every source is going to talk to the other one in order to say what your annual pay is. So if you get $20,000 as a leave check, you get a pension of $30,000 that comes out. You get Social Security of $25,000 that comes out. Each one of those sources and split TSP pull out 40 grand each one of those sources that you have thinks that’s the only income that you’re getting. And so what happens most of the time, except for this last check. This one’s a little different, but with the rest of the sources, between your Social Security, your pension, your TSP, since they don’t talk to each other, they withhold too little in taxes, and retirees end up owing more money at the end of the year. This is one of those rare exceptions that the way the circular E works, the IRS code, the way it works on withholding is that, because you’re getting that leave cash out in January, they withhold a higher amount because they anticipate you’re going to have more income for the year. So that’s the why behind it, which I always find is fascinating, but no does not taxed at a higher rate. Quick little hack on this. If you’re going to be in that situation, you don’t want to repay all these amount in taxes, you can always change your W-4 right? So they withhold less in taxes. That means you have more withholdings, right? So they withhold less in taxes, and it’s going to happen is they’ll withhold less taxes. We like to do it in December before you get that annual check. But then just be really careful you don’t make sure you don’t underpay the IRS, because they can get a little punitive. Kevin, I hope this answers your questions I really enjoy, especially with us at tax questions, I really enjoy you guys submitting your questions. When you have questions like this and how it pertains to your personal situation, pick up the phone and give us a call. Let us know about it, and you could be featured in the next FERS federal fact check. Till then, Happy Planning
