There has been a lot of attention on taxes in the news lately with the most recent tax reform going into effect this year. However, this article is not going to focus on the new law, but rather the broader topic of the experience that federal employees are likely to have with respect to taxes when they are ready to step into retirement.
First, many federal employees wholeheartedly believe that they will be in a lower tax bracket in retirement than they are right now. 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.
Most of these federal employees think they’ll be in lower bracket because instead of receiving their full salary, now they’re going to be receiving a pension (and that pension is typically much less than the salary that they have today). On the surface, it makes sense. However, the idea of being in a lower tax bracket assumes that they are not pulling money from any other place to make up the difference in lost income.
Imagine a scenario where you’re at a certain level of salary, you take a pay cut when you retire (to receive the pension), but then you fill the gap with money from accounts like the Thrift Savings Plan and Social Security — and the vast majority of all that money is taxable as well. If you add it all up, you may end up with the same amount of taxable money coming in which likely means you will be in the same tax bracket as you were before retirement.
When it comes to all of these accounts and sources of income, there are a number of ways that federal employees (or technically, retirees) are affected with respect to taxes. The best way to explain taxes as they apply to federal benefits is to go through each of these benefits one by one and review the tax implications that federal employees have while they are working and in retirement.
The tax consequences in retirement can be overwhelming when you consider all of the benefits you have available to you. Therefore, in this article (Part 1) we’ll cover the tax consequence of benefits paid to you directly from OPM. Stay tuned for the next article (Part 2) where we’ll discuss the tax consequences under FEHB, FEGLI, TSP and more.
CSRS and FERS Pensions
At the federal level, the vast majority of the CSRS and FERS pension is taxable. If you were to look at your pay stub, you’ll see that a certain percentage of your pay gets contributed to the CSRS or the FERS retirement system. For most CSRS employees, that would be 7% of their pay and for most FERS employees, that would be 0.8% of their pay. For some employees who have been hired more recently, under FERS-RAE and the FERS-FRAE, they may have a significantly higher percentage that they have to contribute to FERS. But whatever the dollar amount is that you put into the retirement system, that money has already been taxed. You didn’t get a tax advantage when you contributed each pay period to CSRS or FERS, like you do maybe for TSP. You’ve already paid the tax on the money when it went in, so when it comes out later in the form of a pension, it’s not taxed. But to be clear: it’s only that money that you put in that is paid to you later without being taxable.
The majority of your federal pension is going to be taxed because most of the pension is either the growth on all that money that you contributed to CSRS or FERS, or your agency’s contribution to the CSRS or FERS program on your behalf and all of its growth — and all of those are taxable.
At the end of the year, the Office of Personnel Management (OPM) will use a 1099-R Form to notify retirees what portion of their pension was taxable and what wasn’t for the prior year. OPM is going to do all those calculations for the retiree, but my suggestion to federal retirees is to consider the entire pension taxable. Make sure that you’re withholding enough — do not go on this belief that more of the pension is going to be tax-free than it is. You do not want to be surprised with a tax bill in retirement. If you think it’s bad while you’re working to get a big tax bill, it’s even worse when you’re retired.
But what about the state level? Things get a little bit more complicated here because, of course, we have 50 different states. There are some retiree-friendly states that may be appealing to many. In fact, there are nine states that don’t tax anyone’s pension (because they don’t tax income for any of their residents). Then there are nine other states that specifically don’t tax CSRS and FERS pensions because they’ve made a special rule to exclude this special group of federal retirees from being taxed on their pensions.
The states which do not have any income tax for any of their residents are: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington State and Wyoming. Therefore, of course, they’re also not going to tax the CSRS or the FERS pension. Employees living in these states have absolutely no income tax, so their pension is not going to be taxed either. 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 taxes. The states must get their revenue somehow and this is the way that they’re going to do it. While on the surface, this 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. Keep that in mind if you plan to move to one of these states.
If we look at the other nine states that are considered retiree-friendly, these are states that naturally have income tax for the majority of their residents, 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 it all: 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 have likely more moderate property tax and sales tax because they’re getting the bulk of the state’s revenue through income tax, but not from federal retirees. This is kind of a little bit of a hybrid and may be worth looking at.
Now to be clear, I’m not suggesting that employees or retirees move to one of these special states in retirement. There are so many factors that go into choosing a state where it is most advantageous to live. So hopefully the acknowledgement of these various states helps employees to begin to have these conversations about the tax considerations, where they are likely to be retired.
One tax question that I often hear is, if an employee retires in one state and then moves to another state, which state are they taxed in? Generally speaking, retirees are taxed on the federal pension based on the state in which they live at the time that they receive it. Now there are some minor exceptions and those are determined by the various states. For instance, how long do you have to be present in a particular state in order to claim your residency there? This will vary from state to state and is typically what triggers you being required to pay state income tax in that state for the given year. Consult your tax professional to ensure you are following the rules where you live.
Survivor Benefit Plan
The next natural topic is the Survivor Benefit Plan because it’s connected to the pension. The Survivor Benefit Plan is a way to protect a portion of the federal pension from CSRS or FERS for the benefit of a surviving spouse. In order to have this, the federal employee would begin paying a monthly premium when they retire from federal service. There are two tax implications here, and they happen at different moments in time. The premiums that the retiree pays while they’re still living are pre-taxed. For instance, if you had a FERS pension of $1,000 and had the maximum survivor benefits selected, it would cost you 10% of the pension. So, while your pension was $1,000, you’re only going to get $900, and it’s the $900 that you’re taxed on. You’re not going to be taxed on the $100 that it took to secure the survivor benefit. That’s a great perk for the Survivor Benefit Program. However, once the retiree dies and the spouse begins to receive the monthly benefit (roughly half of the pension), that is fully-taxable to the spouse at whatever their tax rate is at the time that they receive the benefit.
If we’re solely looking inside the Survivor Benefit Plan, there’s nothing that can really be done to change the tax obligation that the spouse has when they receive that money. However, if you’re able to consider a life insurance option instead or perhaps as a supplement to the Survivor Benefit Plan offered by the government — life insurance proceeds are 100% income tax-free. Whoever is the beneficiary of that life insurance policy — that benefit will be tax-free to them. To be fair, the financial planning strategy for the survivor benefit and this life insurance alternative is far more complex, so you want to be very careful and make sure that it’s carefully executed with your financial planner, so all your interests are taken into account.
FERS Special Retirement Supplement
The Special Retirement Supplement was designed to bridge the gap between the time an employee retires from FERS (under age 62) until the time they reach age 62 when they would naturally be eligible for Social Security — that’s how the overall program works. This benefit is fully-taxable to the retiree. Whatever amount you’re getting each month, it’s going to be fully-taxable. I do want to caution you about a tax snafu that can occur with the Special Retirement Supplement. When you retire from federal service, your agency gives you an estimate of your pension and the Special Retirement Supplement once everything’s been sorted out at OPM. However, for the next 9 to 12 months, you cannot expect to get the full payment from OPM. During this interim period, you’ll receive a percentage of the actual pension that’s due to you, but you will not receive the payment from the Special Retirement Supplement.
For some federal employees, this can be upwards of $700 to a $1,000 a month that they’re expecting from the Special Retirement Supplement – but not actually receiving. Eventually, you will end up getting your money when OPM sorts everything out and finalizes the pension. They will look backwards and calculate how many Special Retirement Supplement payments were missed, and they’ll cut you a check for the full amount. However, here’s where the tax problem happens. Let’s say that you’re going to retire on December 31, 2019, and you know for probably a year that you’re not going to get your correct pension during that time. OPM needs time to sort everything out. At the end of 2020, OPM has finally figured everything out what your Special Retirement Supplement is supposed to be, so they cut you a check. But they cut the check in January of 2021.
In January of 2021, the regular Special Retirement Supplement monthly payments also start because presumably you’re still eligible for them. You’ve got this big check for $10,000 or $12,000 that you received in January of 2021 (to make up for SRS payments missed in 2020). Now January, February, March, all the way through the end of the year you’re also receiving the monthly payments – the regular monthly payments from the Special Retirement Supplement. At the end of 2021, you now have double the tax obligation on that money in this current tax year. It’s all well and good if you’ve remained in the same tax bracket, but if by receiving that extra payment in 2021 versus 2020 that pushes you up into a different bracket, then you have a problem. Now the tax burden is so much higher because you’ve been put into a higher tax bracket (and will owe more tax because of it). Of course, the Special Retirement Supplement is only payable up until the age of 62, so this potential tax problem stops at that point in time.