Federal Employees and Taxes in Retirement

In this world, nothing is certain except for death and taxes, as a popular quote would say. And this proved to be accurate as taxes continue to chase citizens even after retirement.

Most people assume that these tax bills won’t be much of a problem when they retire. Still, in contrast to this popular notion, taxes will have a significant impact on your federal retirement. If you fail to consider the dues before entering your post-work years, you will be in for a big upset.

Employees must understand how the tax will apply to their retirement income. Having a firm grasp on this mathematical problem can help you plan to minimize the tax bill for a maximized separation benefits.

While there are tax breaks for older Americans and those who are less well off, it is risky to believe that your taxes will decline in retirement. The Government needs money, and older Americans are the current generation holding a dense portion of wealth. This asymmetry is the reason why only a few older Americans experience tax declines, and it is more likely to continue for future generations.

Federal Pensions Are Taxed

Most pensions are taxable, and the Federal Employees Retirement System (FERS) pension is not safe from this inescapable event. However, there are types of military pensions or disability pensions that are either partially or entirely tax-free. Each year, the Office of Personnel Management or OPM sends a 1099 form, which lists a pensioner’s total pension, the taxable portion of retirement, and the total contributions to the security fund.

Approximately 0.8 percent of a federal employee’s pay goes to the retirement system. For some recently hired employees, under FERS-RAE and FERS-FRAE, they have a considerably higher percentage. However, the amount of the contribution is irrelevant because all remittances to the system are already taxed.

Tax gets deducted automatically when the cash flows into the system, so it is only fair that once a retired person withdraws his money in the form of monthly pensions, it should no longer be taxable. Although this is true, the vast majority of the FERS pension is still liable for the tax. A retiree’s pension is funded, at least in part, by the contributions made to the FERS while employed. It is the only part of the retirement that everyone can consider non-taxable.

The majority of funds in a federal pension generates from the growth of contributed money or the employer’s contribution to the FERS program on your behalf. This stock is the part of the retirement that is considered taxable.

The rules used to determine the taxable portion computation of a retiree’s annuity changed over the years. The Internal Revenue System or IRS uses a so-called “simplified method” to calculate the non-taxable portion of the pension by dividing the total investment by the number of monthly payments. The total investment is the after-tax amount contributed to the retirement system when the retiree was still employed.

The frequency of monthly payments depends on whether the retiree elects to provide a survivor annuity. Otherwise, the system will utilize a separate formula.

Not All Are Exempt From Social Security Benefit Tax 

There was a time when social security benefits were 100 percent tax-free. It was in the year 1987 up to 1993 when the government changed to around 50%. And beginning 1993 up to the present, the taxable portion rose to 85%.

While many social security recipients today are not taxed, there are others, depending on their provisional income, who are not exempt. Taxable Social Security Benefits cover monthly survivor and disability benefits, but not Supplemental Security Income or SSI payments.

Retirees receive an SSA-1099 form every year from when they start receiving their benefits. The SSA-1099 form should contain the necessary information for determining tax liability. Retirees who are receiving social security benefits from more than one source will receive such form for each.

To determine a retiree’s provisional income, take the modified adjusted gross income, add half of the social security benefits, and add all of the tax-exempt interest. The filing threshold for single and joint returns are different.

For single returns, if the provisional income is less than $25,000, then Social Security benefits are tax-free. If the amount is between $25,000 and $34,000, then the taxable money is around 50 percent. Any amount above $34,000 means up to 85 percent of the benefits are payable.

For married couples, If the provisional income is less than $32,000, then Social Security benefits are tax-free. If the amount is between $32,000 and $44,000, then up to 50 percent of the benefits are taxable. Any amount above $44,000 would also increase the payables for up to 85 percent.

TSP Distributions Are Taxable

For Traditional Thrift Savings Plan balances, employee investments, together with agency contributions, are made with pre-tax funds. It means that the entire fund, including the money associated with its growth, is fully taxable upon your resignation. The rate depends on the recipients’ tax bracket at the time of withdrawal.

Roth balances, on the other hand, are funded on an after-tax basis, which means that employee investments are withdrawn tax-free. The associated growth can also be withdrawn tax-free, provided that they meet certain conditions.

For a withdrawal to be deemed qualified, it must be made at least five years after the beginning of the year, which incurred the first Roth investment. The participant should be at least 59 ½ years old, deceased, or disabled. If the condition used is a disability, then the definition in Section 72(m)(7) of the Internal Revenue Code will be considered.

It is vital to specify that the withdrawal would come from the traditional balance if both Roth and old balances coexist in the TSP. Absent such specification, your withdrawal will be taken proportionally, and Roth earnings will be taxed.

Retirees who own both Roth and Traditional balances on their TSP should specify from which of their TSP balances they want the withdrawals to come, particularly if their Roth balance is not qualified. If it isn’t, it is imperative to specify that the entire withdrawal occurs from the traditional balance. Otherwise, the withdrawals will be taken proportionally from both accounts, and the Roth earnings will also receive a cut.