Taxes and Your Federal Retirement

By on July 29, 2013 in News, Retirement

(Editor’s Note: Your financial situation may be unique. FedSmith is not in the business of providing individual retirement or tax advice. There are knowledgeable, talented people who provide this service and write occasional articles for this website such as Ehren Clovis, Micah Shilanski and Carol Schmidlin.  Readers seeking individual assistance may want to contact a financial adviser that will help with planning your financial future during retirement.)

Planning for retirement is a chore and many people prefer to forget about it. When they do serious planning, as most do as they near the age at which they are thinking of retiring after a long career with the federal government, they may quickly total up their monthly income and decide if it is enough for a financially secure retirement.

What many do not take into account is taxes. How will your federal retirement benefits be taxed? The reality is that taxes may have a significant impact on your retirement income.  You do not want to fall into those that engage in “wishful thinking” more than actually planning for your retirement. Here are a few major considerations.

Paying Taxes on Your Federal Retirement Benefits

First, most readers will pay taxes on their federal pension. Whether you are receiving money through the Civil Service Retirement System (CSRS) or the Federal Employee Retirement System (FERS), most of your income will generally be taxed at ordinary income tax rates.

You will not pay taxes on the money you have paid into the retirement system over the years you worked for Uncle Sam. You already paid taxes on the money when it was taken out of your pay check. From comments we see from readers, some think they will not pay income taxes for several years after they retire because they are getting back their actual contributions paid into the retirement system. Unfortunately, it no longer works that way.

While you do get the money back that you have paid in without paying taxes, you receive this money on which you have already paid taxes over your projected life expectancy. Depending on your age when you retirethis means that you may get back the money on which you have already paid taxes over a period of 30 years or more. Most of your retirement income from your federal pension does not come from your own contributions. While those who retired under CSRS paid more into the federal system than those under FERS, most of your pension income will be subject to income taxes regardless of which system you are under.

What About Your Other Probable Sources of Income?

Your Thrift Savings Plan (TSP) withdrawals are fully taxable. You did not pay taxes on the money you contributed into this system. The money you contributed has grown tax free during your federal career.  That does not mean the government has forgotten about taking a bite out of this money when you withdraw it. When planning for your retirement, take this into account. The amount you have to pay will depend on your tax bracket which, presumably, will be lower than the tax bracket you were on during your working years.

One advantage for federal employees is that with the TSP, unlike an Individual Retirement Account (IRA), if you retire in the year in which you turn 55 (or when you are older) there is not an early withdrawal penalty charged for withdrawing this money.

If you have been investing in a Roth instead of the traditional TSP account, your tax situation will be different.

  1. Taxes will be paid up front on contributions to the Roth TSP, which means more money will come out of your paycheck.
  2. Withdrawals from a traditional TSP are taxed as ordinary income when withdrawn. Withdrawals from a Roth TSP are tax-free if five years have passed since January 1 of the year you made your first Roth TSP contribution, AND you are 59 1/2 or older. (See Is the Roth TSP Right for Me?)

The end result is that most of your FERS or CSRS retirement pension income will be taxable. (For more information about the taxation of your federal retirement benefits see IRS Pub 721 )

It is also likely that  your Social Security benefit will also be taxed—depending on your income level. If you retire under the FERS system, start working at another job after you retire and have a significant income, you will want to talk to a tax advisor before you start receiving Social Security benefits. Understanding how to maximize your income from your future Social Security benefits could prevent you giving up some of these benefits because you did not understand how much of your Social Security benefit you are likely to lose if you continue working after your federal retirement. (See The Social Security Tax Cap)

In short, taxes can have a significant impact on your future retirement income. Also take into account that you may also have to pay state taxes on your income, depending on the tax laws in your state. (Also see Working After Retiring From Government: Plan in Advance for a Potential Tax Hit)

Other Drains On Your Retirement Income

No one wants to outlive your source of income during retirement. Keep in mind you may be drawing on these sources of income for about 30 years or so. It is better to err on the side of caution than to be too optimistic.

With this in mind, there are other factors you need to consider that will impact your retirement income or, more accurately, that will impact your purchasing power during retirement.

One common refrain we hear from federal employees is that between their retirement annuity from the government, Social Security payments (for FERS employees), and a withdrawal rate of about 4% from the Thrift Savings Plan will provide a sound, financially secure retirement.  Obviously, CSRS employees will be a little different but most still anticipate being financially secure under the CSRS program.

That conclusion may be accurate for most people. But be sure to take these factors into account in your planning process.

Historically, inflation has averaged about 3.4%. The cost of your health insurance and and the amount you will have to pay when using medical services, are going up—usually faster than the official rate of inflation.  You should probably anticipate an inflation rate of 4% or so. Some readers will anticipate higher rates of inflation because of the rate at which we are increasing our debt and printing (or digitizing) an increase in our money supply.

When you retire, you will also receive a COLA in most years. This increase will probably be about 2.4%, on average. Unfortunately, there is also a good chance that the calculation for these annual increases will be decreased in the next year or two. (See The “Chained CPI” and Your Federal Retirement Package).

The net result may be that, as you go through your years of retirement, you may find that you withdraw significantly more from your TSP and other retirement accounts to match your spending. When you do your personal planning, or sit down with a financial advisor to plan your future retirement spending and income, keep the reality of inflation in mind.

What If You Live Overseas?

When you retire, you are no longer bound to one location in order to keep your job. A number of retired Americans take the opportunity to live outside of the United States for a variety of reasons.

While there may be many benefits if you choose to do this, remember that your tax situation may change.  Living outside of the country may have numerous benefits. Reducing your tax bill is unlikely to be one of the benefits though because of how the U.S. tax system is structured.

For U.S. income tax purposes, your Social Security benefits are subject to tax the same way they would be if you lived in the U.S. This may mean that you don’t pay any taxes if you are not making much money but, for most retired federal employees, you will be paying about the same in U.S. taxes just as if you still lived in the United States.

Your federal pension is also subject to U.S. taxes just as if you were still living in the United States. Again, you may also be subject to state taxes if you maintain a residence in the United States.

Tax in the foreign country

Generally, pensions and annuities that are based in the U.S. are free from tax in a foreign country. Social security benefits would generally not be subject to tax by the foreign government in countries that have a tax treaty with the U.S. If there is no treaty, it is more likely that your benefits will be subject to tax. Your citizenship status could also have an effect. If you become a citizen of that country, you may be subject to tax in that country on your world-wide income, just as U.S. citizens and residents are for U.S. tax purposes.

If you earn other income in your adopted country, you may be able to exclude up to $96,000 from U.S. income taxes in 2013 by claiming the Foreign Earned Income Exclusion. This law allows you to avoid paying taxes to two countries on the same income.

Many countries base their tax systems on where you live and not your citizenship. Before picking up and leaving for a great adventure in a foreign country, you would be well advised to check with a tax lawyer in both the United States and the country in which you will be living. Keep in mind that, in addition to income taxes,  you could also be liable for estate taxes in a foreign country—as well as estate taxes to be paid to the United States government should die while living abroad.

The Net Result

Federal employees are in much better financial shape than most Americans will be when they retire. You have a guaranteed annuity; you have had access to one of the best retirement vehicles available to anyone through the TSP; and you will receive a COLA throughout your retirement years.

This article is designed to help you realistically plan to balance your income and expenses in what is likely to be a long retirement after a career of federal service. Planning your future now may help you have a happier and more financially secure retirement future.

© 2016 Ralph R. Smith. All rights reserved. This article may not be reproduced without express written consent from Ralph R. Smith.

About the Author

Ralph Smith has several decades of experience working with federal human resources issues. He has written extensively on a full range of human resources topics in books and newsletters and is a co-founder of two companies and several newsletters on federal human resources.

34 Replies

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  1. mandinka says:

    Why move to a low tax state?? You should feel good about paying your fair share like our exhaled leader Obama says

    • retired worker fed says:

      Your comment really shows no common sense. Tax planning is a reasonable consideration when making decisions. Your fair share is the tax you owe based on the law. Of course, if the law is wrong, then it should be changed.

      • mandinka says:

        Did you miss the 2012 election. Barak wants everyone to pay their fair share as does all democrats except in Barak’s case his secretary paid a higher % than he did

        • retired worker fed says:

          Please substantiate your position that the secretary paid a higher percentage than Obama. This may be true of Romney, but I would not know because I did not see the Secretary’s return. Your comment makes no sense and is another error on your part.

          • mandinka says:

            Barak’s tax rate was 19% and his secretary paid 22%

          • retired worker fed says:

            And your source for this is…? IRS does not leak secretary’s or the president’s 1040.

          • mandinka says:

            1st off the IRS leaked Romney’s tax returns for the past 10 years to Harry Reid, they leaked the gal from DE who ran for Senate. So your premise is wrong to begin with.
            The Wash Times published the sec tax rate and barak published his 2011 tax return. But then again if you read a news paper you wouldn’t have to ask these foolish questions

          • retired worker fed says:

            No Mandinka. The IRS did not leak any of these returns. The person who would have done this would have been fired and prosecuted. This could be part of UNAX. So name the person who who did the leak and show your source.

          • mandinka says:

            Utter Nonsense. The IRS under Barak has been used more for political tricks then even Nixon thought possible

          • retired worker fed says:

            Please supply us the source of your information for these leaks. TIGTA would want to know about this.

          • mandinka says:

            Well lets start with Harry Reid knowing Romeny’s tax returns and the Delaware candidate for Senate who had her tax info “leaked” to name just a few

          • retired worker fed says:

            Again, how do you know what Reid knows about Romney’s actual returns. He may know that Romney has assets from other sources, but that is different. A similar thing applies to the Delaware Senate candidate. Your accusations based on speculation are pure garbage.

          • mandinka says:

            How?? Seriously??? Reid made much to do about it during the 2012 campaign

          • retired worker fed says:

            After Romney disclosed his return and it was found that Romney’s tax rate was low due to all of his investment income subject to the 15% tax rate. Would you like to try again? Your IRS disclosure comments are false. Another mistake.

          • johnnyb says:

            if youre a corporation, just have your assets in the cayman islands and you pay no taxes

  2. Fed_Peasant says:

    Muni bonds are worth a look, to include high yield (junk) municipal bond funds.

    • wombat1951 says:

      Only if you buy the actual bond and hold them to maturity. Buying bond funds right now is very risky….they are going to crater when interest rates start to go up again, as they will.

      Also — muni bond shoppers need to do their due diligence WRT whose bonds to buy. Detroit, Stockton, Harrisburg are tip of the iceberg. Be very conservative regarding the issuing entity of any muni bond you are interested in.

  3. NYC retiree says:

    If you retire at the year’s end under FERS, don’t start collecting social security until the year after the new year. In the first year after you retire, you will receive “as wages” one or two paychecks and your unused annual leave. That will mean higher taxes on your pension and social security will ask you for money back thinking you “worked” that year. Happened to me.

    • formerIRS says:

      Why miss out on a whole year of Social Security. Simply retire in Oct or Nov so that your last paychecks and annual leave payment are paid prior to the end of the calendar year. You are right in the sense that this is indeed a booby trap

  4. Norm from GA says:

    Thanks for explaining the tax exemption part of the annuity; I am in my first year of retirement, and it seemed to me that OPM’s tax withdrawal seemed too small, but hopefully it is because the exemption is already calculated in.

    You should have mentioned the TSP tax withdrawal system is rather strange in this respect. Even though as you mentioned, all money taken out is fully deductible, instead of allowing you to chose the percentage to be deducted based on your tax bracket, as does social security, it is mandated to presume that this is your prime source of income, and must allow all your deductions and such before figuring your taxes. The only way to work around this is to figure the actual tax, and either request that they add the difference to their withdrawal, or set the money aside elsewhere. But, IMHO, this seems like a lot of extra figuring on our part, and I am sure that many retirees with suffer sticker shock when they find at tax time how little was withdrawn from their TSP distribution that they will have to make up.

    [Or maybe it will turn out that they knew what they were doing, and their method works after all.]

    • Rambo1957 says:

      If taking money out of your TSP, they take out a mandatory 20%. You can adjust your taxes two ways, increase the dollar amount from you annuity or file Form TSP-79 to go above the mandatory amount. Social Security is taxed up to 85% of the total amount. Taking your annuity, TSP and Social Security (minus the 15%) and plugging it into a tax calculator will give you a close representation for what you will be expected to pay in taxes.

      • Norm from GA says:

        Not really… I am withdrawing $1900 per month, and they deduct $23.33 for Federal Taxes. That ain’t no where near 20%, or my eventual tax bill. Perhaps you are thinking of a one-time total withdrawal, or periodic payments over a period of less than ten years. For periodic payments over a longer period of time, or based on life expectancy, they calculate the tax with the assumption that you are married, with three dependents, and, like I said, having no other income. And, like I mentioned, I would think it would be rather unlikely that someone would be making periodic withdrawals from TSP without also getting a pension, or earning income elsewhere.

        • Rambo1957 says:

          You are right. I always looked at the TSP chart and assumed the periodic payments were taxed at least at 20%. My plan was to, if I needed to, take some out for a five year period until my wife got her SS. So in that scenario, I would pay at least 20%. Complete the withholding section of Form TSP-78 to increase your withholding. Glad you pointed this out to me. Can’t believe I missed this after all these years. Thank you Norm.

          • Norm from GA says:

            You are certainly welcome. That TSP chart is not the easiest one to read or follow.

            BTW, GA is very pension friendly, and state and local property taxes usually get cut significantly for senior citizens.

            And…NO SNOW, or salt on the roads, at least here in middle GA. Cars bodies last forever!

  5. wombat1951 says:

    For those who have the desire and ability to move, moving from a high tax state [like Maryland] to a low tax state [like TN or TX or FL] can have a dramatic effect on your tax bill post retirement.

    Have a relative who retired as a FED from MD. Moved to a no state income tax state. This relative calculated their taxes in their first full year in the new state as if they still lived in MD, and found that they paid over $14K less in their new State than if they remained in MD. No state income tax and lower property taxes were the main contributors to the difference.

    So while usually not a driver for the decision, moving can be financially rewarding as well as providing one with a location more amenable to a person’s other needs and desires. Tax hells like MD can be put in the rear view mirror by many, and doing so can reap significant rewards!

    • Keeg says:

      Smart move, most of the northern states will suck the life out of you in the name of taxes. VT, NH, NY, NJ, MD just to name a few.

      • Rambo1957 says:

        No state income tax on public pensions in New York.

        • wombat1951 says:

          It helps…but NY is one of the worse tax hells out there. They get it from you in so many other ways 🙂 E.G — highest gasoline tax in country at over 50 cents/gallon, and about the highest sales tax @ over 8.5%. Not known for bargain property taxes, either 🙂

          • Rambo1957 says:

            While true, the property taxes take a nosedive from northern Dutchess County north. Westchester County is brutal.

        • HRGuy71 says:

          No state income tax on public pensions (or any other income) in Florida. Property taxes also generally lower. In many cases, property values are higher in Florida though than many parts of New York State as population is growing in Florida and economy is generally good. NYC is different from much of the rest of the state of NY which looks more like an economic wasteland (with high taxes) in portions of the state. Of course, anyone who wants to snow ski or go ice skating will not like Florida. 🙂

    • thinkaboutit says:

      Except those no income tax states hit you with higher salers taxes and higher property taxes. Your government doesn’t come free even in TN, TX or FL.

  6. Robert Benson says:

    Correction: your annuity per se is not part of the formula. Your contributions to the retirement fund are. The program asks for total contributions to the fund.

  7. Rambo1957 says:

    A reminder that unless you were in a law enforcement position, your health premiums are not tax deductible for retirees. It helps to live in a state that does not tax public pensions. Here is a tax calculator:

    http://www.calcxml.com/calcula

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