Estimated Tax Penalties for New Retirees and the Age-62 Waiver

For forty years, an employer withheld tax from every paycheck. Then you retired. Now the income comes from a pension, an IRA, Social Security, and maybe a part-time consulting gig, and nobody is responsible for making sure enough tax is paid during the year except you.

That is why the estimated tax penalty under IRC 6654 so often shows up in the first or second year of retirement. Here is how the penalty works, the safe harbors that prevent it, and the waiver Congress wrote for new retirees.

How the penalty works

IRC 6654(a) adds an amount to your tax when you underpay estimated tax. It is computed like interest: the IRS underpayment rate under section 6621, applied to the amount of each quarterly underpayment, for the period it was underpaid. There are four required installments, generally due April 15, June 15, September 15, and January 15 of the following year.

Withholding counts. Under section 6654(g), tax withheld from wages, pensions, IRA distributions, and Social Security is treated as paid in equal parts on each installment date, unless you elect to use the actual dates.

The safe harbors

You generally owe no penalty if your withholding and timely estimated payments equal at least the lesser of:

• 90 percent of the tax shown on this year's return, or
• 100 percent of the tax shown on last year's return, or 110 percent if last year's adjusted gross income exceeded $150,000 ($75,000 if married filing separately), under section 6654(d)(1)(C).

Two more exceptions in section 6654(e): no penalty if the tax shown on your return, minus withholding, is less than $1,000; and no penalty if you had no tax liability for the prior full year and were a U.S. citizen or resident all year.

The prior-year safe harbor is the new retiree's friend. If your income dropped after retirement, last year's tax may be easy to match through withholding.

Why retirees get caught anyway

1. A big lump sum in the retirement year. Severance, unused vacation pay, a pension lump sum, or a large IRA withdrawal with only 10 percent withheld.
2. Social Security with no withholding. Up to 85 percent of benefits can be taxable under IRC 86. See why retirees owe tax on Social Security.
3. Pension defaults. Withholding calculated as if the pension were your only income. See withholding on pensions and IRAs.
4. Capital gains from selling a home outside the section 121 exclusion, a rental, or investments to fund the move to Florida.
5. A Roth conversion. See the Roth conversion tax bill.

The waiver for newly retired taxpayers

Section 6654(e)(3)(B) says no addition to tax shall be imposed for an underpayment if the IRS determines that:

1. You retired after reaching age 62, or became disabled, in the tax year for which estimated payments were required or in the year before, and
2. The underpayment was due to reasonable cause and not willful neglect.

Read that closely. It covers the year you retire and the following year. It requires that you retired after reaching 62, or became disabled at any age. And it requires reasonable cause. Being new to estimated taxes after a career of employer withholding, and not realizing the pension and Social Security were under-withheld, is the kind of explanation the provision was written for. Be specific about your facts.

A separate waiver in section 6654(e)(3)(A) applies when a casualty, disaster, or other unusual circumstance makes the penalty inequitable. Pinellas retirees who lived through a hurricane evacuation, flooding, or a lengthy displacement may fit that one, and the IRS often grants automatic deadline relief for federally declared disasters as well.

Disabled before retirement age

The disability prong of section 6654(e)(3)(B) has no age requirement. A 58-year-old who stops working because of a disability and starts drawing on retirement savings, with nothing withheld, can request the waiver for the year of disability and the following year, if the underpayment was due to reasonable cause. Include documentation of the disability and its onset date with Form 2210.

How to request the waiver

You request it on Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts. The form has a part where you check the box that applies, whether you are requesting a waiver of all or part of the penalty, and you attach a statement explaining why you qualify, with supporting documents. For the retirement waiver, include your retirement date, your age at retirement, and a short explanation of why the underpayment happened. Follow the current Form 2210 instructions, since line numbers change.

If you already received a notice assessing the penalty without having requested the waiver, you can still ask for it in response to the notice or afterward, in writing.

The estimated tax penalty is not eligible for first-time abatement, which covers failure-to-file, failure-to-pay, and failure-to-deposit penalties. The 6654 waivers are the relief route here.

The annualized income method

If most of your income arrived late in the year, for example a December IRA withdrawal or a fourth-quarter stock sale, the annualized income installment method in section 6654(d)(2) may reduce the penalty for earlier quarters. You use Schedule AI of Form 2210 to show when the income was actually received. It takes more work, and it can make a real difference in a retirement year with lumpy income.

An example

A Clearwater engineer retires in June at 64. Through June, her paycheck withholding was right for a full-time salary. From July on, she receives a pension with default withholding, starts Social Security with no withholding, and takes a $40,000 IRA distribution in October to pay off her car and a credit card, with 10 percent withheld. When she files, she owes several thousand dollars, and Form 2210 shows a penalty for the third and fourth quarters.

She retired after 62, in the tax year at issue. She has never made estimated payments in her life, and the underpayment came from the switch from wages to retirement income. That is a strong section 6654(e)(3)(B) waiver request. She should also fix next year's withholding before January, because the waiver applies only to the retirement year and the year after. The facts are illustrative.

How the penalty is calculated

The penalty is not a flat percentage. Section 6654(a) applies the underpayment rate under IRC 6621, which is the federal short-term rate plus 3 percentage points, adjusted quarterly. It runs on each quarterly shortfall from that installment's due date until the shortfall is paid or until the original due date of the return, whichever comes first. A small shortfall paid quickly costs little; a large one left unpaid all year costs more.

One timing rule helps people who file early. Under section 6654(h), if you file your return and pay the full balance by January 31 of the following year, no penalty applies for the fourth installment that would otherwise be due January 15.

Because the rate floats with federal short-term rates, the same shortfall can cost noticeably more in a high-rate year than in a low-rate one. Form 2210 and its instructions apply the correct rates for each period, so let the form do the arithmetic.

Preventing it next year

• Use the prior-year safe harbor: make sure total withholding at least equals last year's tax, or 110 percent if your AGI was over $150,000.
• Set up W-4V withholding on Social Security and adjust W-4P on the pension.
• Use a December IRA or RMD withholding election to catch up, taking advantage of the 6654(g) even-payment rule.
• Recheck after any big change: a spouse's death, a home sale, starting RMDs.

Next step

If you retired after 62 in the year of the penalty or the year before, ask for the waiver. It is in the statute. If the penalty is one item in a larger IRS balance you cannot pay, call (813) 229-7100. The firm's page on penalty abatement covers the penalties that first-time abatement does reach.