Tax time is closer than you think. Here are 13 things you should know about taxes and your federal retirement.
1) Payroll taxes are not taken out of retirement income; only earned income. Therefore, you will not be paying Social Security tax (6.2%) and Medicare tax (1.45%) from any of your retirement income.
2) Pension contributions are not taken out of retirement income. They are taken out of your federal salary if you are employed in a position covered by CSRS, FERS or one of the other federal retirement systems. FERS pension contributions are 0.8% for most employees and 1.3% for special category employees such as law enforcement officers, firefighters, etc. CSRS pension contributions are 7% for most employees and 7.5% for special category employees. CSRS Offset pension contributions are the same as for FERS employees. FERS employees hired after 01/01/2013 have larger pension contributions, but none of them will be retiring soon, so we will not deal with that here.
3) TSP deductions do not come out of retirement income either as retirees are not allowed to contribute to the Thrift Savings Plan.
4) For federal income tax purposes all of our retirement income (pension, Social Security, TSP, IRAs, etc.) is taxed as ordinary income; that is, the percentage we pay in federal income tax is based on the marginal tax bracket where the income falls.
5) Your CSRS or FERS pension is not fully taxable as you contributed to your pension out of already taxed dollars. You will not be double taxed on your contributions. You will, however, be taxed on the government’s untaxed contributions, as well as on the earnings that accrue on both your contributions and the government’s contributions.
How much does the government contribute towards your pension? For CSRS the government contributes as much as you do (7% or 7.5%). For CSRS Offset and FERS the government contributes at a different rate each year (based on Treasury returns). In 2015, the government contributed 13.2% and in 2016 they will be contributing 13.7% for regular employees; special category employees have a larger share paid by the government.
For tax purposes, you are viewed as recouping your already taxed contributions bit-by-bit over your life expectancy. This means that the vast majority of your pension will be subject to federal income tax. The only thing that could be considered good news about this is that, for most retirees, OPM calculates how much is taxable and how much is viewed as a return of your already taxed contributions, and lists the amounts on the form 1099-R that they mail you each January. IRS Publication 721 contains more than you want to know about the taxation of your federal pension.
The amount of your pension that is taxable is based on the amount of your contributions and upon your age at the time you retire. Here’s an example for an employee receiving $35,000 per year in pension benefits who retired at the age of 57 and had contributed $50,000 towards his/her pension.
|Total pension received||$35,000|
|Total retirement contributions||$50,000|
|Life expectancy in months (based on IRS life expectancy table in Publication 721)||360|
|Tax free amount per month (divide contributions by life expectancy in months)||$138.89|
|Tax free amount per year (monthly figure x 12)||$1,666.68|
|Taxable portion of pension (total pension minus annual tax free amount)||$33,333,32|
6) You elect how much you want to have withheld from your pension by filing form W4-P with your retirement papers. You can change withholding after retirement by requesting a change from OPM. Retirees should avail themselves of OPM’s “Services Online” to make changes to withholding and other items.
7) Up to 85% of Social Security benefits can be taxed. The amount of your Social Security that can be taxed is based on your “provisional income.” To determine your provisional income, you add together one-half of your Social Security, all of your taxable income and certain non-taxable income (e.g., tax-exempt income etc.). Your provisional income is compared with thresholds established for single and joint filers. These thresholds have never been indexed for inflation since they were established in 1983.
Single filing status thresholds:
- If the total of the above items is less than $25,000, there will be no tax on SS benefits;
- If the total is between $25,000 and $34,000, up to 50% of SS will be taxable;
- If the total is over $34,000, up to 85% of SS will be taxable.
Joint filing status thresholds:
- If the total of the above items is less than $32,000, there will be no tax on SS benefits;
- If the total is between $32,000 and $44,000, up to 50% of SS will be taxable;
- If the total is over $44,000, up to 85% of SS will be taxable.
I tell participants in the pre-retirement seminars that I conduct for my firm, Federal Career Experts, that most federal employees can count on having 85% of their Social Security benefits subject to federal income tax. Agency Human Resources or Training staff can contact Federal Career Experts to find out more about our seminars.
8) Federal income taxes are not automatically withheld from your Social Security. If you want federal income taxes withheld from your Social Security, you have to request it. It is a good idea to have taxes withheld, as it helps you avoid a nasty surprise at tax time.
9) Withdrawals from a traditional TSP balance are fully taxable.
10) In most circumstances, you will pay no tax on withdrawals from your Roth TSP balance. You will never be taxed on the part of your Roth withdrawal that represents your contributions, as you contributed to the Roth out of already taxed dollars. You will not be taxed on the portion of your Roth withdrawal that represents earnings if your withdrawals are qualified. In order for a withdrawal to be considered qualified, you must be at least 59 ½ at the time of the withdrawal and you must have had a Roth balance in your TSP for at least five years. This means that a withdrawal from your Roth balance will not be considered qualified until at least 01/01/2017, and then only if you are over the age of 59 ½.
This gets problematic for those who plan on retiring and withdrawing money from their TSP before they reach the age of 59 ½ as you are not allowed to separate withdrawals between your traditional and Roth TSP balances. Per IRS regulations, withdrawals within a defined contribution account must be taken proportionately from before and after tax money. The TSP could fix this by allowing us to have separate Traditional and Roth accounts, rather than having separate balances within one account.
11) As the TSP is a tax deferred employer retirement plan, there are penalties for taking money out too early, or too late.
The 10% early withdrawal penalty will not apply to withdrawals from your Traditional TSP if you retire from your federal job in the year in which you turn 55, or later (50 for Law Enforcement Officers, Firefighters, Customs and Border Protection Officers and Air Traffic Controllers). It will also not apply to withdrawals taken by an individual who is totally and permanently disabled. Individuals who retire from their federal job before the year in which they turn 55 (50 for Law Enforcement Officers, Firefighters, Customs and Border Protection Officers and Air Traffic Controllers) can avoid the penalty if:
- They elect monthly payments based on the IRS life expectancy table and continue those payments for five years, or until they turn age 59 ½ whichever is longer; or
- They purchase a TSP annuity.
Though most defined contribution plans like the TSP have a 50% penalty for failing to take required minimum distributions beginning at the age of 70 ½, the TSP has provisions in place that shield almost all participants from the penalty. The penalty is 50% of the amount of money you should have taken out, but didn’t.
- If you are still working at your federal job at 70 ½, you are not required to take a minimum distribution.
- If you are taking substantially equal monthly payments at 70 ½ (the most popular withdrawal choice of those who do not roll their TSP account into an IRA or other instrument) and fail to take out enough to meet the minimum required distribution, the TSP will send you an additional payment of the required amount before the end of the year.
- If you are not working and haven’t begun withdrawals by 70 ½:
- The TSP will notify you at the beginning of the year after the year in which you turned 70 1/2 that you must begin taking out your money by April 1;
- If you do not begin withdrawing the money by April 1, the TSP will transfer all your money into the G fund;
- If you do not begin withdrawing your money within nine months, you forfeit your account. But don’t panic, once you begin taking required minimum distributions and pay the penalties, the TSP “un-forfeits” your account.
12) Take care in setting up your TSP withholding. The default withholding amount depends on your withdrawal choice. A tax notice is updated annually and can be found in the “forms and publications” section of the TSP’s website. The notice has a detailed table that describes how each type of withdrawal is treated for tax purposes (e.g., periodic payment, eligible rollover distribution, etc.) and what the default withholding rate is. The default withholding rate for most monthly payments is very low and will result in retirees who do not change it to owe taxes (and perhaps penalties) at tax time.
13) Most states have income taxes. Some states with income taxes do not tax any retirement income. Some states with income taxes give retirement income preferential treatment.
Every year the National Active and Retired Federal Employees Association (NARFE) prepares a detailed list of how the various states tax federal retirement benefits. NARFE members can access that list on the NARFE website, or see in in one of the Spring issues of the NARFE magazine. Kiplinger provided a “Retiree Tax Map” that covers all taxes that are of interest to retirees.