An eligible retiring employee covered by either the Civil Service Retirement System (CSRS) or the Federal Employees Retirement System (FERS) may elect the alternative form of a CSRS or FERS annuity, or AFA. With an AFA, a retiring employee receives a lump sum payment consisting of the employee’s CSRS or FERS contributions (which have already been taxed), which are nonrefundable retirement contributions made via payroll deduction, civilian service credit deposits, military service credit deposits, redeposits for withdrawn CSRS or FERS contributions, in addition to an actuarially reduced CSRS or FERS monthly annuity.
In order to elect the AFA option, the employee must:
- Be eligible to retire under the non-disability retirement rules;
- Have a life-threatening illness or other critical medical condition; and
- Not have a former spouse entitled to court ordered benefits based on the employee’s Federal service. A physician’s statement certifying the existence of a life-threatening condition must be attached to the employee’s retirement application along with a statement indicating interest in making the AFA election.
The following are examples of life threatening conditions:
- Class IV (any physical activity brings on discomfort and symptoms that occur at rest) cardiac disease with congestive heart failure;
- Respiratory failure;
- Emphysema with respiratory failure;
- Cardiac aneurysm;
- Active AIDS; and
- Aplastic anemia.
Lump Sum Payment and Federal Income Tax Liability
The lump sum payment received under the AFA option consists of a tax-free portion and a taxable portion. The tax-free portion represents a portion of the employee’s “cost” in the CSRS or FERS retirement – the employee’s total contributions made to CSRS or FERS retirement and disability fund via payroll deduction, and deposits and redeposits. Note that those contributions and deposits and/or redeposits were made with after-taxed dollars and therefore will not be taxed again when these contributions and deposits are withdrawn. The taxable portion of the lump sum payment is the total interest that has accrued within the CSRS and FERS Retirement and Disability Fund through the years on behalf of the retiring employee.
The taxable portion of the lump sum payment can be directly transferred to a “rollover” traditional IRA. If a retiring employee electing the AFA option requests such a direct transfer, then taxes will be deferred on that portion of the lump sum payment until it is withdrawn from the traditional IRA.
The taxable portion of the lump sum payment does not qualify as a lump sum distribution eligible for capital gain treatment or 10-year lump sum averaging. If an employee separates from service before the calendar year in which the employee reaches age 55, the taxable portion of the lump sum payment will be subject to Federal and state income taxes and to a 10 percent early withdrawal penalty.
The following worksheet is used to calculate the taxable portion of the lump sum payment:
Note that in order to complete the worksheet, a retired employee needs to know the amount of the employee’s lump sum credit and the present value of the contract. These terms are now explained.
• Lump sum credit. In general, this is the same as an employee’s total contributions made via payroll deduction to the CSRS and/or FERS Retirement and Disability Funds. These contributions were made with after-taxed salary dollars. It also includes deposits and interest that were made for Federal employment during which no retirement contributions were taken out of an employee’s salary and deposits made for military service deposits; it includes redeposits including interest for any refunds of retirement contributions that a departed employee received and did not repay. If an employee owes any deposits or redeposits for civilian service and elects the AFA option, the deposits and redeposits are deemed to have been paid when computing the retirement benefit.
• Present value of the annuity contract. The present value of the annuity contract is calculated using actuarial tables provided by the IRS. Those individual who are receiving a lump sum payment under the AFA option need to write to the following address to find out the present value of their annuity contract:
Internal Revenue Service
Attn: Actuarial Group 2
1111 Constitution Ave, NW PE-4C3
Washington, DC 20224-0002
The following is an example that illustrates:
Charles retired from federal service under FERS in 2017, one month after his 60th birthday. Charles had contributed $30,000 to FERS during his 25 year Federal career and qualified to receive a lump sum payment of that amount under the AFA option. The present value of his annuity contract is $150,000.
The tax free portion and the taxable portion of the lump sum are determined using the worksheet below. The tax-free portion ($6,000) and the taxable portion ($24,000) are shown on lines 4 and 5, respectively. The taxable portion of $24,000 is Charles’ net cost in the FERS which is used to calculate the taxable part of his reduced annuity (see below).
Note that Charles can request that OPM directly transfer the fully taxable $24,000 portion of his lump sum payment into a rollover traditional IRA. If he does, he will not pay income tax on the $24,000 until he withdraws the funds from his traditional IRA.
Lump Sum Payment Made in installments
If an employee chooses the AFA option, the retired employee will receive the lump sum payment usually in two equal installments. The first installment will be paid by OPM shortly after the employee retires. The second installment will be paid with interest in the next calendar year. Exceptions to the installment rule are provided for cases of critical medical need.
Even though the lump sum payment is made in installments, the overall tax treatment is the same as if the entire payment was paid at once. If the payment has a tax-free portion, then the recipient must treat the taxable portion as received first.
These annuitants who have chosen to receive a lump sum payment under the AFA option will also receive reduced monthly annuity payments. These annuity payments will have a tax-free and a taxable portion. Under the Simplified Method, the tax-free portion of the monthly annuity is compute as discussed in a previous MFR column. However, the annuitant’s “cost” in the retirement plan (CSRS or FERS) will not include the tax-free portion of the lump sum payment made under the alternative annuity option. For example, Charles “cost” in the plan will not include the $6,000 received tax-free as part of his lump sum payment.
The AFA election will not affect the amount of the survivor annuity benefit. However, an AFA election does require the written consent of the current spouse. In the case of a former spouse who is entitled by a court order to a survivor benefit or a portion of the retirement benefit, the law prohibits election of an alternative form of annuity – even if the former spouse consents.