Federal retirement expert, Chris Kowalik, explains why taxes can derail an otherwise great retirement plan.
Taxes can potentially wreak havoc on your retirement since you have to pay for them somehow—and if you’re not accounting for them, you may be forced to use your hard-earning savings. I refer to taxes as the “carbon monoxide” that can kill an otherwise really good financial plan. It can sneak up on you quickly and without a lot of warning.
Many federal employees are confused when it comes to how their taxes will change in retirement. Here are a few common myths that you should know and avoid.
Myth #1: You’ll be in a lower tax bracket.
First, most federal employees believe that they will be in a lower tax bracket in retirement than they are right now. In reality, what actually ends up happening is that most people end up in the exact same tax bracket that they are in right before they retire from federal service.
But how could this happen? Didn’t you just take a big pay cut to retire?
It’s easy to see why this confusion can occur. In retirement, instead of pulling your full salary, you’re going to be pulling in a pension that is typically much less than the salary you have today. However, the idea of being in a lower tax bracket assumes that you’re not pulling money from any other places. Plus, as a federal retiree, you’ll now be taxed on the money you use to pay your FEHB premiums (something you didn’t have to do while you were working!).
Imagine a scenario where you’re at a certain level of salary and you take an obvious pay cut to receive your pension in retirement. However, because you still want the same standard of living in retirement, you need to fill in the income gap.
If you do so with money from accounts like the Thrift Savings Plan (TSP) and Social Security — the vast majority of which are taxable – you will be right back in the same tax bracket as you were before retirement.
Remember, there are only two reasons people end up in a significantly lower tax bracket when they retire:
(1) because they have significantly less money to live on in retirement (but who wants that?!), or
(2) because they PLANNED to be in a lower tax bracket by implementing smart tax strategies when they were younger.
Myth #2: You should move to a tax-friendly state when you retire.
When it comes to state taxes, there are some retiree-friendly states. In fact, there are nine states that don’t tax anyone’s income (including pensions). Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington State and Wyoming have no income tax for any of their residents. Federal employees living in these states have absolutely no income tax, so their pension is not going to be taxed either.
Sounds great, right? But before you start packing up your things and getting ready to move, you need to know that’s only half of the story. Although these states don’t have any state income tax, the reality is that in states that have no income tax, they typically have higher sales tax and property tax.
The states must get their revenue somehow and this is the way that they’re going to do it. While on the surface, it sounds great to not have to pay state income tax, there are some consequences with respect to the other kinds of tax that you might experience. Read up carefully before you pack the moving truck!
There are also nine other states that do have income tax but have specifically excluded the taxation of the entire CSRS and FERS pensions. No matter how high it is, these nine states will not tax your pension: Alabama, Hawaii, Illinois, Kansas, Louisiana, Massachusetts, Mississippi, New York and Pennsylvania.
In addition to these nine states, there are five states that give an exemption to a certain amount of the pension and each one of these are different: Kentucky, Michigan, North Carolina, Oklahoma and Oregon. These 14 states tend to have moderate property tax and sales tax because they’re getting the bulk of the state’s revenue through income tax, just not from federal retirees.
Again, I’m not suggesting that you move to one of these special states in retirement. There are so many factors that go into choosing a state where it’s most advantageous to live. Hopefully, the acknowledgement of these various states helps you to have these conversations about the tax considerations and where you’re likely to be retired.
Myth #3: My Social Security benefits won’t be taxed.
Unfortunately, it’s not just your retirement account withdrawals that are taxed – some of your benefits may be taxed as well. To really understand how Social Security benefits are taxed, you must look at both the federal and the state levels. At the federal level, roughly 85% of your Social Security benefit is taxable.
Given the level of income that most federal retirees will have with their pensions, you can pretty much bank on 85% of your Social Security benefit being taxed. Out in the private sector, there are ways to get out of being taxed on Social Security. It takes a lot of prior tax planning, but given that federal retirees have a taxable pension, you won’t be able to avoid being taxed on Social Security benefits at the federal level.
There are only 13 states that tax Social Security benefits: Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont and West Virginia. Again, this is not a reason to move to or move out of a given state. It’s just simply something that you need to consider in your retirement planning so that there are no tax surprises when you begin drawing your Social Security.
Myth #4: I only have to pay taxes on the money I put in the TSP.
Most employees know that there are taxes due on the back end of their traditional Thrift Savings Plan (TSP). Of course this happens because no tax was paid on the money that was put into the TSP (called “tax deferred”). However, what many federal employees don’t understand is that they don’t just owe tax on the principal, they also owe tax on all of the growth.
For example, let’s say you contribute $100,000 into the traditional TSP (over a long period of time), and that $100,00 grows to $200,000. Then the principal that you originally contributed ($100,000) was not taxed at the time and the growth ($100,000) has not been taxed yet – but don’t worry, the IRS won’t forget!
Therefore, if you were to withdrawal this $200,000 (either all at once or over a long period of time), you owe the tax on the entire $200,000 — not just the money you put in, but all the growth, too!
Don’t let taxes surprise you in retirement.
My best advice with respect to taxes is to recognize that they’re very real in retirement. Take the time to work with your tax professional or financial planner and put a tax strategy in place. A little tax planning will help protect your retirement savings in the long run.