Why the Tax Cut Reduced Pension Checks and Why It Doesn’t Matter

Many retirees were surprised when their January pension checks were smaller than their December payments. Pension plans had increased withholding for federal income tax, shrinking net benefits. But pensioners shouldn’t worry—they’ll get it all back next year when they file their federal tax returns. It’s only a matter of timing.

What’s going on? The 2010 tax act extended every provision affecting retirees. If anything, inflation adjustments should have reduced withholding.

In fact, as TPC colleague Joe Rosenberg pointed out to me, new withholding tables from the IRS adjusted not only for inflation but also for the expiration of the Making Work Pay (MWP) credit that Congress created in 2009 to help stimulate the economy. Withholding dropped in the spring of 2009 so workers would get a small chunk of their tax cut in every paycheck. When the credit died at the end of 2010, taxes went back up and so did withholding.

All else the same, everyone who got MWP for 2010 will pay more income tax this year and the increased withholding will pretty much cover the higher tax. But the FICA payroll tax that finances Social Security will drop, thanks to a one-year cut included in the tax bill. For many workers, that cut more than offset the increased withholding so their paychecks got bigger. Not everyone benefited from this trade-off, however. As I noted in TaxVox last December, 50 million low-income workers will actually owe more in combined income and payroll taxes because their FICA payroll tax cut was smaller than the MWP credit they lost.

The story is different if you are retired. If you don’t work, you don’t pay the FICA tax so its lower rate doesn’t help you. You didn’t get the MWP credit either since the credit applied only to wage income. Bottom line: Your taxes won’t change. But the IRS changed withholding tables for everyone, and, as of January 1, retirees’ withholding went up and their pension checks got smaller. Note that that didn’t affect every retiree: A person who draws a pension for one job but continues to work at another will benefit from the payroll tax cut.

How much difference does that make? A single retiree drawing a $1,000 monthly pension will see each month’s check cut by a little more than $30, not quite $400 over the year. A couple getting $2,000 a month will receive nearly $50 less each month—almost $600 over the year. Less income means less spending and hence less economic stimulus. Of course, those retirees will get the extra withholding back when they file their 2011 returns, at least to the extent that they’d had enough withheld during the year to cover their tax bills.

Exactly the reverse happened two years ago. Pension checks got bigger when the IRS adjusted withholding tables to incorporate MWP. Retirees’ tax liability didn’t go down then since they didn’t qualify for the credit. Reduced withholding meant bigger pension checks during the year but also a smaller refund—or a payment to the Treasury—come tax filing time. That might have boosted the economy if pensioners spent the extra cash during the year but smaller refunds surely had the opposite effect the following April.

It all comes down to our complex income tax and the approximations of withholding. The IRS tables aim to make sure that enough money is withheld during the year to cover April tax bills. As a result, most of us get refunds and seem glad to do so. That big check surely beats having to write one of your own, even if it does mean you loaned the government money at no interest. But a one-size-fits-all set of tables can be way off for some taxpayers.

This year’s smaller pension checks demonstrate once again the problem of using our complex tax system to do more than simply collect revenue. In a simpler world, retirees wouldn’t have to wonder why their checks suddenly shrank.