Edward A. Zurndorfer, Certified Financial Planner

Before discussing the mechanics of how the federal government taxes CSRS and FERS annuities, it is important to review how and how much CSRS, CSRS-Offset, and FERS employees contribute to their respective retirement systems.

CSRS employees. Employees contribute each pay date 7 percent of their after-tax salary to the CSRS Retirement and Disability Fund. Employee CSRS retirement plan contributions are returned tax-free to annuitants as part of their monthly CSRS annuity payments and until the total CSRS contributions are paid back in full during the annuitant's retirement. The procedure to calculate the tax-free portion of the CSRS annuity is presented below. Consider the following example:

John, a CSRS employee, earns $104,000 a year or $4,000 gross salary each pay date. After federal and state income taxes and Medicare Part A Hospital Insurance tax (1.45 percent) are deducted, John's after-tax salary each pay date is $2,500. Seven percent of $4,000 is $280. The $280, John's contribution to the CSRS Retirement and Disability Fund, is deducted from John's net pay (after all taxes are deducted) of $2,500.

CSRS-Offset employees. Same as CSRS employees except that they contribute 0.8 percent (.008) of  their after-tax salary to the CSRS Retirement and Disability Fund and 6.2 percent of their gross wages is contributed to Social Security (FICA tax). CSRS-Offset employees also receive back their CSRS contribution during their retirement as part of the CSRS annuity check and until the contributions are paid back in full. The same procedure for receiving back their CSRS contributions is used for CSRS Offset annuitants as is used for CSRS annuitants. This procedure is presented below.

FERS employees. Employees contribute 0.8 percent (if hired before Jan. 1, 2013)or 3.1 percent (if hired after Jan. 1, 2013) of their after-tax salary to the FERS Retirement and Disability Fund. The 0.8 percent is contributed on an after-tax basis. Employee FERS plan contributions will be returned tax-free to FERS annuitants as part of their monthly annuity and until the total FERS contribution is paid back in full during the annuitant's retirement. The procedure to calculate the tax-free portion of the FERS annuity is presented below. Consider the following example:

Joan, a FERS employee, earns $78,000 a year or $3,000 gross salary each pay date (26 pay dates during the calendar year). After federal and state income taxes, FICA and Medicare Part A Hospital Insurance taxes are deducted Joan's net pay is $2,000. 0.8 percent of $3,000 is $24.00. The $24.00 is deducted each pay date from Joan's net pay (after all taxes are deducted) of $2,000 (not from the gross pay of $3,000).

 Rules for Determining the Taxable Portion of a CSRS or FERS Annuity

Shortly after a CSRS, CSRS Offset or FERS employee retires from federal service, the employee will receive from the Office of Personnel Management (OPM) an annuity statement showing the date of approval of the employee's annuity. The statement will also show: (1) The commencing or annuity starting date; (2) The gross monthly rate of their annuity benefit, and (3) The annuitant's total contributions to the CSRS Retirement and Disability Fund, to the FERS Retirement and Disability Fund, or to both funds. CSRS employees who voluntarily transferred to FERS in 1987/88 or in 1998 with at least five years of CSRS service -- these are called TransFERS employees - would have contributed to both funds. These three elements are explained below:

• Annuity starting date. If an employee retires from federal service on a regular annuity, then the employee's annuity starting date is the commencing date on the retired employee's annuity. Delays in payment of the retired employee's annuity such as a because of a late application do not affect the date the retired employee's annuity begins to accrue or the annuity starting date.
• Gross monthly rate. This is the amount a retired employee is to receive after any adjustment for electing a survivor's annuity or for electing the lump sum payment under the alternative annuity option but before any deduction for income tax withholding, insurance premiums etc. The gross monthly rate is adjusted annually by any cost-of-living adjustments (COLAs).
• Employee "cost" (or contributions to CSRS and/or FERS). The "cost" of a retired employee's CSRS and/or FERS annuity is the total of the employee's contributions to the CSRS and/or FERS retirement plans via payroll deduction (as discussed above) during the employee's federal service, as shown on the retired employee's annuity statement from OPM. . If an employee made a deposit for service in which no retirement contributions were deducted such as prior military service or redeposited contributions that they had withdrawn from the CSRS and/or FERS retirement plan when they left federal service, then the entire deposit or redeposit  (including interest paid), is included in the employee's "cost".
• Recovering employee cost tax-free. How a CSRS or FERS annuitant  calculates the tax-free recovery of the employee cost of the CSRS or FERS annuity depends on the annuitant's annuity starting date. In particular: (1) If the annuity starting date is before July 2, 1986, either the Three-Year Rule or the General Rule applies to the CSRS and /or FERS annuity; (2) If the annuity starting date is after July 1, 1986 and before Nov. 19, 1996, then the annuitant could have chosen to use either the General Rule or the Simplified Method; and (3) If the annuity starting date is after Nov, 18, 1996, then the annuitant must use the Simplified Method.

Since all employees retiring this year and in the future must use the Simplified Method, the discussion will be on the Simplified Method.

Under the Simplified Method, each of an annuitant's monthly payments is made up of two parts, namely:

1. The tax-free part that is a return of the employee now annuitant's CSRS or FERS retirement contributions; and
2. The taxable part that is the federal government's contributions to the CSRS and/or FERS retirement contributions and accrued earnings within the CSRS and FERS retirement funds. The tax-free portion of a CSRS and FERS annuity is a fixed dollar amount that remains the same, even when the CSRS and FERS annuity is increased by COLAs.

The tax-free portion of a CSRS and FEDRS annuity continues throughout the annuitant's life and the survivor annuitant's life if the annuitant is providing a survivor annuity. This will continue until the "employee's cost"  - the employee's total contributions to the CSRS and FERS Retirement and Disability Funds and deposits/redeposit - is paid back in full. The Simplified Method below discusses how the tax-free portion of the annuity is computed.

A deduction is allowed for the unrecovered cost of the annuity if the cost of the annuity has not been fully recovered at the annuitant's or the survivor annuitant's death. The deduction is claimed on the annuitant's (or the survivor annuitant's) final tax return as a miscellaneous itemized deduction and not subject to the two percent of the adjusted gross income limit.

To determine the taxable portion of a CSRS or FERS annuity, an annuitant must use the Simplified Method to calculate the tax-free portion of the annuity. OPM routinely determines that the taxable portion of the annuity as shown in the following 2012 CSA 1099-R issued by OPM.

Sample CSA 1099-R

The following worksheet and accompanying tables are used to compute the taxable portion of David Brown's annuity, starting date was April 1, 2012, and whose first annuity check was May 1, 2012.

Note the following about Dave's retirement annuity:

1. Dave was age 65 at the time of his retirement;
2. Dave is providing a full survivor annuity to his wife Arlene, who was age 57 at the time of Dave's retirement;
3. Dave completed the worksheet below. To complete line 3 of the worksheet, he used Table 2 and found that 310 is the number in the second column, opposite the age range that includes 122 (his and Arlene's combined ages). Dave calculated on line 4 that the portion of his annuity -- the return of his "cost" in the retirement plan -- is $100 each month. If Dave lives to collect more than 310 monthly payments, he will generally have to include in his gross income the full amount of any annuity payment received after 310 payments have been made.

If Dave does not live to collect 310 monthly payments and his wife begins to receive monthly payments, she will also exclude $100 from each monthly survivor annuity payment until 310 payments -- a combination of her payments and Dave's -- have been made. If she dies before 310 payments have made, then assuming Dave has filled Form 2808 (CSRS) or SF 3102 (FERS), Designation of Beneficiary for CSRS or FERS contributions, then the beneficiary(s) will receive in a lump sum payment any remaining CSRS or FERS contributions.

Dave keeps a copy of the worksheet in his files in order for Arlene to know what portion of her survivor annuity is tax-free. This is important because OPM does not provide the taxable portion of a survivor annuity. This will be explained in the next column discussing how federal retirement benefits are taxed.

Posted: 02/18/2013

About the Author

Edward A. Zurndorfer is a Certified Financial Planner, Chartered Financial Consultant, Chartered Life Underwriter, Registered Health Underwriter, Registered Employee Benefits Consultant and Enrolled Agent in Silver Spring, MD -- and the owner of EZ Accounting and Financial Services, an accounting, tax preparation and financial planning firm also located in Silver Spring, MD.  Zurndorfer is also is an instructor at federal employee retirement seminars throughout the country and writes numerous columns and books on federal employee benefits.