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How Federal Retirement Benefits are Taxed - Part VI: Lump Sum Benefits
There are occasions in which a federal retiree, a beneficiary, or a survivor of a deceased employee or retiree may be the recipient of some type of a lump sum employee benefit. This column discusses the tax consequences of the various lump sum employee benefits. While the information presented may not apply for current year taxes, the information should be of use to employees who will be retiring in the future as well as to beneficiaries and survivors of deceased employees and retirees.
Lump Sum Benefits for Employees or Retirees
Unused annual leave
Upon retiring or leaving federal service, an employee will receive a lump sum payment of all unused annual leave hours. The lump sum payment is made by the employee's payroll office. The payment is subject to federal and state income taxes and payroll taxes that are normally deducted from an employee's paycheck. The following table summarizes these taxes:
Depending on an employee's federal and state tax bracket, a retiring or departing employee could lose a significant amount of their annual leave payment to taxes, as the following example illustrates:
Paul, age 60, a FERS employee retires from federal service with 400 hours of unused annual leave. At the time of his retirement, Paul's hourly wage rate was $50/hour. The following summarizes Paul's gross and net payment of his unused annual leave.
A suggestion for minimizing the overall tax bite on a lump sum payment for unused annual leave is for an employee to retire in late December or early January. By retiring during this time, a retired employee will receive the lump sum payment (directly deposited into their bank account) sometime in January or early February. Assuming that the retiree will not be working in this new calendar year, he or she will therefore have less income during the year and most probably be in a lower federal and state income tax bracket compared to the previous year. The employee should therefore request (at least three weeks before their retirement date) that less federal and state income taxes be withheld from the employee's lump sum payment for unused annual leave.
Single payment (full withdrawal) from a traditional TSP account
If a TSP participant requests a lump sum payment of his or her traditional TSP account, then the entire TSP account proceeds are subject to federal and state income tax. The TSP will automatically withhold 20 percent in federal income taxes.
As a result of receiving a lump sum payment of the traditional TSP account, the payment could "push" the TSP account owner into a higher federal and state income tax bracket. For example, if a single TSP account owner is in a 25 percent federal tax bracket and receives a $500,000 lump sum payment during 2013, then the lump sum payment could push the participant into a 39.6 percent bracket, currently the highest federal tax bracket. This means that the participant during 2013 would have to pay an additional 14.6 percent of $500,000, or $73,000 of federal income taxes, at the time of filing his or her taxes. Single traditional TSP lump sum payments are therefore highly discouraged.
Refund of CSRS and FERS contributions
If an employee leaves federal service or transfers to a job not under the CSRS and FERS and is not eligible for an immediate annuity, then the employee can choose to receive a refund of the employee's contributions to the CSRS or FERS retirement account. The refund will include both regular and voluntary contributions made to the fund, plus any interest payable.
If the refund includes only the employee's contributions, then none of the refund is taxable. If it included any interest, the interest portion is taxable unless that portion is directly rolled over into another qualified retirement plan or to a traditional IRA. Note that interest is not paid on CSRS and FERS contributions unless an employee had at least one but fewer than five years of CSRS or FERS service. The interest portion is also subject to a 10 percent early withdrawal penalty if an employee leaves federal service before the calendar year the employee reaches age 55.
Lump Sum Benefits for Survivors and Beneficiaries
Life insurance proceeds
The life insurance proceeds paid to a beneficiary of a life insurance policy owned by a deceased federal employee or retiree are income-tax free. It makes no difference the type of life insurance -- a term policy or a cash value policy, or whether the policy is through the Federal Employees Group Life Insurance (FEGLI) program or through a private insurance company, the policy proceeds are federal and state income tax-free.
FERS Basic Employee Death Benefit (BEDB)
A spouse of a deceased FERS employee (with at least 18 months of federal service prior to death) is entitled to a death benefit. This death benefit is equal to 50 percent of the deceased employee's annual salary as shown on his or her SF 50 in the year of death. The spouse is also entitled to a payment amount that started out at $15,000 in 1987 and has been increased by cost-of-living adjustments since then. The amount is $31,316.46 for 2013.
At the option of the surviving spouse, the benefit can be taken in the form of a single payment or in the form of a special annuity payable over a three year period. If the single (lump sum) payment is chosen, then the following rules apply:
- If a FERS survivor annuity is not paid, then at least part of the special death benefit is tax-free. The tax-free part is an amount equal to the deceased employee's FERS contributions; and
- If a FERS survivor annuity is payable (a deceased FERS employee must have had at least 10 years of federal service in order to give a survivor annuity) then all of the special death benefit is taxable. None of the employee's FERS contributions can be allocated to the BEDB special death benefit.
Lump sum payment of CSRS or FERS contributions
If a federal employee dies before retiring and leaves no one eligible for a survivor annuity or is ineligible to give a survivor annuity because he or she had less than 10 years of federal service, then the estate or other beneficiary will receive a lump sum payment of the CSRS or FERS contributions made via payroll deduction. This will also include an accrued interest to the extent not already paid to the employee. A CSRS or CSRS Offset employee makes a beneficiary designation for this payment by completing and submitting form SF 2808; a FERS employee completes and submits form SF 3102.
The beneficiary is taxed only on the amount of any accrued interest in the year the lump sum is distributed or made available.
Lump sum payment at the end of survivor annuity
If an annuity is paid to a CSRS or FERS employee's survivor and the survivor annuity ends before an amount equal to the deceased employee's contributions (to CSRS or FERS) has been paid, then the remainder of the contributions will be paid to the employee's estate or other beneficiary, as designated on form SF 2808 (CSRS) or SF 3102 (FERS). Generally this beneficiary will not have to include any of the lump sum payment in gross income.
Voluntary contributions to CSRS through the Voluntary Contribution Program (VCP)
A CSRS employee who made voluntary contributions to the CSRS Retirement and Disability Fund through the VCP and who dies before retiring from federal service cannot use these contributions to provide an additional annuity to survivors. Instead, the voluntary contributions plus any accrued interest will be paid to the estate or to other beneficiary. The beneficiary generally must include any interest received in income for the year distributed or made available. But the portion of the lump sum payment consisting of CSRS contributions is tax-free. The interest portion of the lump sum payment is subject to mandatory 20 percent federal income tax withholding.
Thrift Savings Plan (TSP)
The payment received as the beneficiary of a decedent's traditional TSP account is full taxable. A surviving spouse who requests a direct transfer to a traditional IRA will not be taxed until the funds are withdrawn from the traditional IRA. A spousal beneficiary may also request that a TSP beneficiary participant account be established for the spousal beneficiary. The money in the account is not subject to federal and state income taxes until it is withdrawn.
Nonspousal TSP beneficiaries who request direct transfers of inherited TSP account to an "inherited" or "death" IRA will not be subject to income tax until they withdraw money from the "inherited or "death" IRA. Minimum required distributions (MRD) from the "inherited" or "death" IRA must begin the year following the death of the TSP participant and made every year. The IRS penalty for not taking a MRD in any year is 50 percent of what was not distributed.
Social Security death benefit
The Social Security lump sum benefit payment of $255 is paid to the surviving spouse of a deceased individual who died either "fully" or "currently" insured under Social Security. The lump sum payment is completely federal and state tax-free.
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.