In working with young Federal retirees covered by the Federal Employees Retirement System (FERS), I have noticed a common psychological trend.
Most people contemplating retirement from the government who are still in their fifties plan on going back to work in the private sector—many at wages comparable to what they are already earning as a federal employee.
The overwhelming thought for many is: “I am going to have a lot of money when I retire and go back to work.” This may be true but a funny thing happens on their income tax return after they have retired and have landed a new, well-paying job.
The example below shows what happens to a married couple when each person makes $50,000 a year. One works for the government and retires with a $30,000 a year pension while going back to work at the same salary for another employer.
This example was carefully crafted to show what the results are within the 25% tax bracket. All additional income is taxed at a full 25%.
Be Careful When Filling Out the Tax Form
This is a tax of $625 a month on the additional income. The real problem arises when you fill in the Form W-4P to instruct FERS to tell the government how much tax to withhold from your income. Most people want to put “Married and One Exemption” on that form. Making this election on a $30,000 pension indicates a withholding of $113 a month and a “Married and Zero” election only increases the withholding to $158 a month. (See the graphic below for a depiction of the W-4P form referenced here.)
Will You Be Shocked When Writing a Big Check?
At “Married and Zero,” you are still short $467 a month and are going to write a check for $5,604 at the end of the year (most likely with an underpayment penalty tacked on). Most people with defined benefit retirement plans are shocked at this result but you must make up the difference from the pension or from your withholding on the new job.
If you actually retire and do not return to work the results are not so dramatic. The withholding tables assume that the income it is withholding on is the only income you have.
This gives the bad result above if a spouse continues working or the employee goes back to work. The good news is that there is an easy solution to the problem.
Form W-4P does not have a percentage withholding indication on it but in our case you simply increase the number of exemptions to ten which will result in no withholding.
Next, there is a line on the form for any additional amount you want withheld per pay period and, in our example, just put $625 on that line and the problem is solved.
This does not ease the sting of being taxed at a flat 25% on the retirement income when only $13,300 of your other income was taxed at that 25% rate.
When You Actually Retire and Don’t Work
And there is more good news!
When you actually do both retire you can do a new projection and reduce the withholding. A good certified public accountant (CPA) can take your information and create a projection and get you close to the correct withholding from all sources.
It is a good idea to get a plan tailored to your specific tax situation in advance so that you take the correct tax out of the pension or cover it elsewhere. If you are not an existing client of a CPA it is best to get this done in the May to November time frame since they are occupied with their regular clients the other months of the year.
Also, keep in mind if you are subject to bonuses in the new job or other income fluctuations it is far more difficult to plan and might require periodic updates. You will need to provide a prior year return, your FERS amount expected and what your new employment should pay as well as any expected changes in itemized deductions.
This example does not include state taxability but your planner can inform you of the status of your state.
This example was intended to be relatively simple but there is a new generation of retirees where both spouses may have been employed at incomes up to or over $100,000 and pensions in the $50,000 to $60,000 range.
This can result in total income with a retirement income stream over $300,000 which puts you squarely in the 33% tax bracket. Seek advice and get a plan if you find yourself in this position!
| Original Position | Spouse A | Spouse B | Total |
| W-2 | 50,000 | 50,000 | 100,000 |
| Retirement | – | – | – |
| 50,000 | 50,000 | 100,000 | |
| Standard Deduction | (11,400) | ||
| 2 Exemptions Under 65 | (7,300) | ||
| Taxable Income | 81,300 | ||
| 2009 Tax | 12,706 | ||
| Maximum Bracket | 25% | ||
| Tax as a percentage of Income | 13% | ||
| With Retirement | Spouse A | Spouse B | Total |
| W-2 | 50,000 | 50,000 | 100,000 |
| Retirement | 30,000 | – | 30,000 |
| 80,000 | 50,000 | 130,000 | |
| Standard Deduction | (11,400) | ||
| 2 Exemptions Under 65 | (7,300) | ||
| Taxable Income | 111,300 | ||
| 2009 Tax | 20,200 | ||
| Maximum Bracket | 25% | ||
| Tax as a percentage of Income | 16% | ||
| Tax on the Additional | |||
| Retirement Income | 7,494 | ||
| Tax as a percentage of $30,000 | 24.98% | ||
| Tax as a percentage of $30,000 | 0.00% | ||
| Original Position | Spouse A | Spouse B | Total |
| W-2 | 50,000 | 50,000 | 100,000 |
| Retirement | – | – | – |
| 50,000 | 50,000 | 100,000 | |
| Standard Deduction | (11,400) | ||
| 2 Exemptions Under 65 | (7,300) | ||
| Taxable Income | 81,300 | ||
| 2009 Tax | 12,706 | ||
| Maximum Bracket | 25% | ||
| Tax as a percentage of Income | 13% | ||
| With Retirement | Spouse A | Spouse B | Total |
| W-2 | 50,000 | 50,000 | 100,000 |
| Retirement | 30,000 | – | 30,000 |
| 80,000 | 50,000 | 130,000 | |
| Standard Deduction | (11,400) | ||
| 2 Exemptions Under 65 | (7,300) | ||
| Taxable Income | 111,300 | ||
| 2009 Tax | 20,200 | ||
| Maximum Bracket | 25% | ||
| Tax as a percentage of Income | 16% | ||
| Tax on the Additional | |||
| Retirement Income | 7,494 | ||
| Tax as a percentage of $30,000 | 24.98% | ||
| Tax as a percentage of $30,000 | 0.00% |
Stephen Kincer is a Certified Public Accountant with Kincer Business Group, Inc., a member of Providence Financial Center in Huntsville, Alabama.
