(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 retire, this 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.
- Taxes will be paid up front on contributions to the Roth TSP, which means more money will come out of your paycheck.
- 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.
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