This column discusses how survivor annuity benefits are taxed by the Internal Revenue Service. Last week’s column discussed how Civil Service Retirement System (CSRS) and Federal Employees Retirement System (FERS) annuities are taxed by the IRS. In particular, it was discussed how much of a CSRS and FERS annuity is taxable, in accordance with the IRS’ Simplified Method.
In discussing how CSRS or FERS survivor annuities are taxed by the IRS, it is important to discuss how a survivor annuity is taxed under the following two scenarios: (1) A retired employee dies in retirement before receiving all of his or her contributions to the CSRS and/or FERS Retirement and Disability Funds; and (2) A CSRS- or FERS-covered employee dies “in service” before starting to receive his or her CSRS and/or FERS annuity.
Children survivor benefits are paid to the eligible children of deceased employees or annuitants. Eligible children include unmarried children younger than age 18 and children between age 18 and 22 and who are full-time college students. Those children who were disabled before age 18 are eligible for children survivor benefits that continue indefinitely unless the child marries. Note that unlike a survivor annuity benefit in which a retired employee has chosen to give to a survivor annuity to a spouse or to an insurable interest resulting in a reduction to the annuity, there is no reduction to an annuitant’s annuity in order to give children survivor annuity benefits.
Retired Employee Dies in Retirement Before Receiving All of His or Her CSRS or FERS Contributions
As discussed in the column on how the tax-free portion of a CSRS or FERS annuity is determined using the IRS’ Simplified Method, the tax-free amount remains fixed, even when the annuity is increased by annual cost-of-living adjustments (COLAs).
If the survivor annuity benefit is provided for a surviving spouse only, then the same tax-free monthly dollar amount that applied to the annuitant’s CSRS or FERS annuity will be used by the surviving spouse annuitant until the deceased employee’s contributions are paid back in full. The following example illustrates:
Jeff retired from Federal service under CSRS on June 29, 2016. He received a CSRS annuity that provided a CSRS survivor annuity benefit to his wife, Francine. His annuity starting date was July 1, 2016 and he received his first CSRS annuity check on Aug. 1, 2016. His CSRS monthly annuity benefit started at $4,000 per month and using the Simplified Method, the amount of his tax-free monthly amount is $300, as shown in the following worksheet. Note that at the time of his retirement Jeff, was 65 and Francine was 57, for a combined age of 122 years.
Jeff died in March 2017. Francine received her first CSRS survivor annuity in April 2017. She received a gross survivor annuity payment of $2,500 each month between April 1 and Dec. 31, 2017, or $22,500 for 2017. Of the $2,500 monthly survivor amount, $300 is a return of Jeff’s total contributions to the CSRS Retirement and Disability Fund ($93,000 – his “cost” in the plan) and therefore not taxable. The $300 tax-free portion of the CSRS survivor annuity will continue for 310 months (25 years and 10 months, starting from Aug. 1, 2016).
Jeff’s Simplified Method Worksheet (for 2016) is presented here:
Annuitants and survivor annuitant should be aware that OPM does not inform survivor annuitants as to the tax-free portion of a survivor annuity. Please note the following sample 2017 CSF 1099-R, which informs a survivor annuitant of civil service survivor annuity benefits paid in during 2017. In particular, note Box 2, which shows the taxable amount of the survivor annuity is marked as ”UNKNOWN”. However, OPM’s retirement office knows what the taxable amount of the survivor annuity is because the same tax-free monthly amount that was used by the annuitant applies to the survivor annuitant. It is therefore important that annuitants inform their survivor annuitants as to the tax-free monthly portion of the annuity, in order that same tax-free monthly portion amount be continued for the survivor annuitant.
Sample Form CSF 1099-R (annuity benefits paid to a survivor annuitant) for 2017
Employee Dies in Service and Survivor Annuity Starts Immediately
If a federal employee dies in service and is providing a survivor annuity, then the survivor annuity will start the month after the employee dies. Note that in order to provide a survivor annuity, an employee must have at least 10 years of federal service.
How is the tax-free portion of a survivor annuity computed under these circumstances? The survivor annuitant will receive the employee’s “cost” tax-free. The deceased employee’s “cost” is the total of the CSRS and/or FERS retirement contribution that were deducted from the employee’s paychecks during the years of federal service through and including the deceased employee’s last paycheck.
The following discussion covers only the Simplified Method. Once again, a survivor annuitant must use this method if their annuity starting date is after Nov. 18, 1996. Under the Simplified Method, each of the monthly annuity payments is made up of two parts: (1) The tax-free part that is a return of the employee’s “cost”; and (2) The taxable part that is the amount of each payment that is more than the part that represents the employee’s cost. The tax-free portion remains the same, even if the annuity or survivor annuity is increased by COLA’s.
Surviving Spouse With No Children Receiving Children Survivor Annuity Benefits
Under the Simplified Method, a survivor annuitant figures the tax-free portion of each full monthly annuity payment by dividing the employee’s “cost” by a number of months based on the age of the survivor annuitant in the year of the employee’s death as shown in Table 1 of the Simplified Method Worksheet above. Here is an example:
Donna, age 42, began receiving a $1,800 monthly survivor annuity in June 2017 after her husband Carl died in May 2017. Carl had contributed $7,800 to FERS during his 15 years of Federal service. Using the Simplified Method worksheet, Donna divides $7,800 (line 2 of the worksheet) by 360 (line 3, which was obtained from Table 1 based on Donna’s age of 42). $7,800 divided by 360 is $22 (rounded). Of the $1,800 FERS monthly survivor annuity, $22 is a return of Carl’s cost and is tax-free.
Surviving Spouse with Children Receiving Children Survivor Annuity Benefits
If the survivor benefits include both a life annuity for the surviving spouse and one or more temporary annuities for the deceased employee’s children, an additional step is needed under the Simplified Method to correctly allocate the monthly exclusion among the beneficiaries.
The total monthly exclusion for all survivor annuitants is determined by completing lines 2 through 4 of the Simplified Method Worksheet as if only the surviving spouse is receiving a survivor annuity. In order to calculate the monthly exclusion for each survivor annuitant, multiply the calculated tax-free monthly amount on line 4 of the worksheet by a fraction. For each survivor (spouse/insurable interest and children) annuitant, the numerator of the fraction is the survivor annuitant’s monthly annuity amount and the denominator of the fraction is the total of the monthly annuity payments of all the survivor annuitants. The following is an example:
Same facts as the previous example, except that Donna has a seven year old child, Rachel. Under the provision that provides the children survivor annuity benefits, Rachel was entitled to receive $511 per month during 2017. Using the worksheet, Donna determines that $22 of the survivor annuity is tax-free. Donna must change the $22 monthly exclusion to include the allocation between her own annuity and that of her daughter Rachel.
To find out how much of the monthly exclusion to allocate to her annuity, Donna multiplies the $22 monthly exclusion by the fraction $1,800 (her monthly amount)/$2,311 (the total of her $1,800 and Rachel’s monthly $511 child survivor annuity benefit).
$22 x ($1,800/$2,311), or $17.14
Rachel’s tax-free monthly annuity amount is
$22 x ($511/$2,311), or $4.86
A child’s survivor annuity normally ends at age 18 (or at age 22 if the child is a full time college student). The conclusion of a child’s temporary annuity does not affect the total monthly exclusion computed under the Simplified Method. The total exclusion simply needs to be reallocated at that time among the remaining survivor annuitants. The surviving spouse is entitled to the entire monthly exclusion as was originally calculated in the Simplified Method Worksheet if the surviving spouse is the only individual left drawing a survivor annuity.