Don’t get stuck with a tax bill in retirement: The federal retiree's guide to tax withholding 

The dilemma

So, you’re filing taxes after your first year of retirement, feeling good about your anticipated refund. Now that you’ve switched from your salary to a pension, you must be paying significantly less in taxes, right? 

Then your accountant calls you with some bad news. Not only are you not getting a refund, you actually owe a few thousand dollars. But how can this be?

Understand the shift from “autopilot” to “manual” withholding

While employed, taxes are automatically withheld from your paycheck, and you don't have to think much about it. However, upon retirement, federal employees must shift from autopilot to manual control, taking responsibility for tax withholding themselves. This new obligation can be daunting due to its impact across multiple income streams, including your FERS pension, TSP withdrawals and potentially Social Security benefits. Making informed decisions about withholding can help you avoid unexpected tax bills, penalties for underpayment or unnecessarily large withholdings that reduce your monthly income.

Understanding your retirement tax situation

Remember, employment income is taxed differently than retirement income, so while your FERS pension and traditional TSP withdrawals are generally taxable at the federal level, portions may be tax-free at the state level depending on where you live. Roth TSP withdrawals, if qualified, are entirely tax-free. Social Security benefits may be partially taxable based on your total income.

Your overall tax bracket might also change in retirement. Some retirees find themselves in a lower tax bracket due to reduced income, while others may maintain similar income levels through their combined retirement benefits and face similar tax requirements.

Your options for TSP withholdings

To receive withdrawals from your TSP account, specifying your preferences is your responsibility. There are three different options from which you can select: 

• A flat percentage for federal tax withholding
• A specific dollar amount
• No withholding (may trigger quarterly estimated tax payments)

The appropriate withholding amount depends on your total income, filing status, deductions and credits. Remember that different withdrawal methods may have different default withholding rates. Lump sum withdrawals typically have a mandatory 20% federal tax withholding, while periodic payments may use the IRS tax tables based on your filing status.

Changing your TSP withholding, however, is an easy process and can be done by submitting Form TSP-78. Or you may make selections during the withdrawal process for lump sums or other distribution types. To provide flexibility as your tax situation changes, the TSP allows you to adjust withholding at any time. 

FERS pension withholding

Your FERS annuity has federal taxes withheld based on your W-4P elections. If you don't specify, the Office of Personnel Management will default to withholding as if you were married with three allowances (which is not the case for many retirees). To change your federal withholding for your FERS pension, complete Form W-4P and submit it to OPM online or by mail.

It's important to note that the FERS pension does NOT automatically withhold state income taxes, and the W-4P does not include state-specific information. 

OPM can withhold state taxes for states with agreements, but you must include your state-specific form or use OPM’s online service center to request state tax withholding after your pension has been established. 

Residents of states that do not have withholding agreements must handle state tax payments themselves. If your state doesn't have an agreement with OPM, making quarterly estimated tax payments is a good way to avoid penalties.

Managing quarterly estimated tax payments

If you need to make quarterly estimated tax payments due to insufficient withholding or because OPM cannot withhold your state taxes, you will need to:

• Estimate your annual tax liability – Many states offer online calculators to help with this calculation. 
• Divide your estimated liability by four.
• Submit payments by the quarterly due dates (typically April 15, June 15, Sept. 15, and Jan. 15). Most states have online payment portals, making quarterly payments fairly easy to establish. 

Missing these deadlines or underpaying may result in penalties and interest charges. The general rule is that you must pay at least 90% of your current year's tax liability or 100% of the prior year's liability (110% for higher-income taxpayers) to avoid penalties.

Strategic planning for retirement tax withholding

With any financial planning, the most effective approach is to assess all sources of income to determine the right strategy. The same is true when considering retirement tax withholdings. Consider these strategies:

• If your FERS pension doesn't withhold enough federal tax, you can increase withholding from your TSP withdrawals to compensate (or vice versa)
• If you can't have state taxes withheld from your FERS pension, you might increase state withholding from other income sources if possible
• Time larger withdrawals strategically to avoid jumping into higher tax brackets
• Consider tax diversification by maintaining both traditional and Roth accounts

Many retirees find it beneficial to work with a tax professional or financial advisor who specializes in federal retirement benefits, especially during the first few years of retirement when you're establishing your withholding strategy. 

Common Mistakes and How to Avoid Them

Several pitfalls can complicate tax withholding in retirement:

• Underwithholding: Not having enough taxes withheld can lead to an unexpected tax bill and possible penalties. Review your withholding strategy annually or whenever your income or deductions change significantly.
• Overwithholding: While getting a large refund might feel good, it means you've given the government an interest-free loan throughout the year. That money could have been working for you instead.
• Forgetting about RMDs: Once you reach age 73 (or 75 depending on when you were born; as of 2025), you must take Required Minimum Distributions from your traditional TSP account along with any other tax-deferred accounts. These withdrawals have tax implications and failing to take them results in severe penalties.
• Ignoring state tax obligations: Even if OPM can't withhold state taxes for your pension, you're still responsible for paying them. Setting up a system for quarterly payments is essential.

Managing tax withholding in retirement requires more attention than during your working years, but with proper planning, it becomes a manageable part of your financial routine. Review your withholding strategy annually, especially after major life changes or tax law updates. Consider consulting with a tax professional who understands federal retirement benefits if you're uncertain about your approach.

By taking control of your tax withholding strategy, you can maximize your retirement income, avoid surprises at tax time and enjoy greater financial composure throughout your retirement years.

Neil Cain and Austin Costello are certified financial planners with Capital Financial Planners. If you don’t feel confident in your retirement tax withholding strategy or would like more information, register for a complimentary check up. For topics covered in even greater depth, see our YouTube page.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. 

Investing involves risk including loss of principal. No strategy assures success or protects against loss. 

A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply. 

This information is not intended to be a substitute for individualized tax advice. We suggest that you discuss your specific tax situation with a qualified tax advisor. 

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.