Retired This Year? First-Year Tax Surprises and How to Handle Them

The final paycheck is rarely a normal one. Accrued PTO, severance, and a year-end bonus are generally treated as supplemental wages, and employers commonly withhold federal income tax on them at a flat 22% (37% on supplemental wages above $1 million in a year). That flat rate has nothing to do with your actual bracket. If the payout lands on top of a year that also includes a spouse's salary, a pension start, or an IRA draw, your marginal rate may be 24% or higher, and 22% under-withholds. If your income dropped enough that your real rate is 12%, the same 22% over-withholds, and you wait for a refund. Either way, the payout is real taxable income in the year you receive it, so ask payroll exactly what is paid and when before you pick a last day.

From your retirement date on, no employer is withholding for you. IRA distributions default to 10% federal withholding unless you elect otherwise on Form W-4R, and you can choose a different percentage, including more or less than 10%. Pension payments, interest, dividends, and capital gains often carry no withholding at all, which leaves estimated payments to carry the load. The penalty safe harbor is 100% of last year's tax (110% if last year's AGI was over $150,000) or 90% of this year's tax, whichever is smaller. Tax withheld from a December IRA distribution is treated as paid evenly through the year, so it can cure shortfalls from earlier quarters. If you pay estimates instead, the fourth-quarter payment is due January 15, 2027.

A partial wage year is also a planning opening. When wages end mid-year, taxable income may fall into a lower bracket than you will see again once RMDs and Social Security start, which can make it a good year for a Roth conversion or for harvesting capital gains. The catch is that every threshold you might cross is set by the same income. IRMAA uses income from age 63 on to set Medicare premiums two years later. Before 65, the ACA 400% of poverty cliff is roughly $84,600 for a two-person household for 2026 coverage. The net investment income tax starts at $250,000 of MAGI for a joint return, and the senior deduction phases out for people 65 and older as income rises. Fill a bracket on purpose, not by accident.

Social Security and health coverage each have their own rules in the first year. If you claim before full retirement age while still working, the 2026 earnings test withholds $1 of benefits for every $2 you earn above $24,480. In the first year of retirement a monthly test generally applies, so months after you retire usually pay in full, but confirm how it applies to you with the Social Security Administration. On health coverage, COBRA lasts up to 18 months at up to 102% of the full premium, and marketplace special enrollment generally must be requested within 60 days of losing employer coverage. Dropping COBRA voluntarily in the middle of the year does not open a special enrollment period. HSA contributions stop once you are on Medicare.

Retirement plan elections made this year are often hard to undo. The Rule of 55 lets you take penalty-free distributions from the 401(k) of the employer you left, if you separated in or after the year you turn 55, but it does not apply to IRAs or to old employers' plans you rolled over. A check payable to you from a 401(k) carries mandatory 20% federal withholding, so a direct rollover avoids both the withholding and the 60-day clock. Employer stock may qualify for net unrealized appreciation treatment, which needs to be planned before the rollover. A pension lump sum versus annuity election is usually irrevocable and generally requires spousal consent. Deferred compensation pays on the schedule you elected years ago, so check those dates rather than assuming you can change them.

Timing and state tax round out the picture. Whether your last day falls in December or January decides which tax year gets the final paycheck and any payouts, and that choice can shift income, and tax, from one year to the next, as covered in our year-end guide for pre-retirees in their 60s. Arizona does not tax Social Security, but it does tax pension and IRA income at a flat 2.5%, and it has its own withholding election for retirement payments. Ask each custodian how to set Arizona withholding on a distribution, since the process differs by firm. Federal and state withholding are separate decisions, so set both on purpose.

If you retired earlier this year, or retire by year-end, treat the next few weeks as a withholding audit. Pull your last pay stub, any severance or PTO statement, your most recent IRA and pension statements, and last year's return. Write down what has been withheld so far, and what income is still coming with nothing withheld. The goal is not to guess, it is to know whether you are on track for the safe harbor before December 31.

Consider an illustrative household: a married couple, both 62. One spouse retires June 30 after earning wages at a $120,000 annual pace, so $60,000 of wages for the year, plus a $30,000 final payout of PTO and bonus. The other spouse keeps working at $120,000. They plan to draw $30,000 from an IRA this year, half in the spring and half in December, with no withholding elected so far, and earn $8,000 of interest and dividends. AGI is $248,000. After the $32,200 standard deduction, taxable income is $215,800 and federal tax is about $36,988. Suppose employer withholding is $8,400 on the retiring spouse's regular wages, $16,800 on the working spouse's wages, and 22% on the payout, or $6,600, for $31,800 in total. That leaves a gap of about $5,200 at filing, and the household is about $1,500 short of the 90% safe harbor of roughly $33,300. If last year's tax was about $35,800, the 110% test would be about $39,400, so the 90% test is the smaller target.

Notice where the gap comes from. The 22% flat rate against a 24% bracket explains only about $600 of it, because the payout is $30,000 and the rate difference is 2 points. The bigger hole is the $38,000 of IRA, interest, and dividend income with nothing withheld. The fix is cheap: in December, when the second $15,000 IRA distribution is due (it is already counted in the $30,000 above), elect 40% federal withholding on Form W-4R, or $6,000. Withholding does not change the distribution or the tax, only when the tax counts as paid. Total withholding becomes $37,800, which covers the $36,988 of tax with about $800 of cushion, and the IRS treats it as paid evenly through the year. This is an illustration with round numbers. It ignores Arizona tax, payroll taxes, credits, and any other income, and actual results depend on the full return.

Next, look at the thresholds before adding income. A lower wage year may leave room to convert some pre-tax IRA money to Roth, but conversion income counts toward the same MAGI that sets IRMAA two years out, determines ACA eligibility before 65, and drives the net investment income tax and senior deduction phase-outs. Run a projection with your real numbers first, and decide the conversion amount second. If you are on a plan that will pay a deferred compensation installment or a pension start date this year, include those dates in the projection.

Finally, sort decisions by deadline. Withholding, conversions, and gift or charity moves close on December 31. COBRA and marketplace choices run on 60-day clocks from the loss of coverage. Pension elections and rollover decisions often have plan-imposed deadlines and may be irrevocable. Most other choices can wait until you have a full-year tax projection. A planner or tax preparer can build that projection in an hour, and it is usually worth doing before the last pay period, not after.

• Assuming the flat 22% withholding on the final payout matches your real bracket, when your marginal rate may be 24% or higher in a year with other large income.
• Taking IRA distributions without checking the W-4R election, so the default 10% federal withholding, or nothing at all on other income, leaves a balance due in April.
• Using last year's tax as the safe harbor without checking whether last year's AGI was over $150,000, which raises the target to 110% of last year's tax.
• Skipping the fourth-quarter estimate due January 15, 2027, when a December IRA withholding election would have covered the year.
• Filling a lower bracket with a Roth conversion or capital gains without checking IRMAA, the ACA 400% cliff, the net investment income tax, or the senior deduction phase-out.
• Dropping COBRA voluntarily in the middle of the year and finding that it does not open a marketplace special enrollment period.
• Cashing out a 401(k) by check, triggering 20% mandatory withholding, or signing a pension election that is usually irrevocable without a full comparison and spousal consent.