Many federal employees don’t realize the impact that taxes will have on their retirement income. But the truth is that if not factored into your retirement planning, taxes can destroy your financial plan. Even if retirement is many years away, understanding how your federal retirement income will be taxed will help you be proactive with your tax planning; so that you can minimize your tax bill and maximize your retirement income.
How Will Your FERS Pension Be Taxed?
Many federal employees don’t realize that at the federal level, the vast majority (95-99%) of their FERS pension will be taxable income. The 1-5% that is not taxable is due to a return of your FERS contributions made over the years. You can see your contributions to the FERS retirement system on your Earnings and Leave (E&L) statement.
Because your contributions are made after-tax, meaning they are taxed before going into the FERS retirement system, those same contributions will not be taxed when paid in retirement. It’s worth noting again that only the amount you contributed (.08 to 4.9%) will not be taxed; most of your pension will be taxed at ordinary rates (at least at the federal level).
Another essential point to make is that if you are eligible for the Special Retirement Supplement (SRS, also known as RAS), it is fully taxable.
Your SRS amount will be fully taxable along with the majority of your FERS pension.
(Resource: IRS Pub 721)
How Will Your Thrift Savings Plan Be Taxed?
The Thrift Savings Plan (TSP) is a qualified retirement plan, which means the plan meets specific IRS requirements and, as such, receives additional tax benefits and protections. The tax benefits you’ll receive and how your withdrawals will be taxed depend on whether you have a traditional or a Roth TSP.
Taxation of the Traditional TSP
Most federal employees know that they’ll have to pay taxes when they take money out of their traditional TSP. And the reason for the taxation on the back end is pretty straightforward; no taxes were paid on the money put into the TSP. Because the traditional TSP allows you to make your contributions before taxes are taken out of your pay, reducing your current overall tax bill, the pre-tax contribution must be taxed upon distribution.
Many federal employees fail to understand that taxes are due not only on the pre-tax contributions but also on the investment growth. Meaning, the total distribution from your traditional TSP will be fully taxable at ordinary tax rates.
Note: If you contributed tax-exempt money (combat pay), your contributions would be tax-free when withdrawn, but your earnings will be subject to tax.
Taxation of the Roth TSP
Unlike the Traditional TSP, Roths allow after-tax contributions and tax-free withdrawals. You pay taxes upfront contributing to your Roth with money that has already been taxed. Once in your Roth, your contributions grow tax-sheltered, and as long as you meet specific IRS requirements, your withdrawals are tax-free during retirement.
The Roth TSP acts as the opposite of the traditional TSP.
Note: If you contributed tax-exempt money (combat pay) to your TSP, once you are eligible for withdrawals, you can receive tax-free income and tax-free contributions and earnings from your Roth. In other words, your investment is completely tax-free.
Required Minimum Distributions (RMDs)
Required minimum distributions (RMDs) kick in at age 72 for both the traditional and Roth TSPs. Yet, active federal employees who work past age 72 can delay taking them until they retire.
Moving money from your Roth TSP to a Roth IRA will eliminate RMDs. As RMDs are required from the Roth TSP but not from a Roth IRA.
How Are Social Security Benefits Taxed in Retirement?
Some federal employees are surprised that their Social Security benefits are taxable. But because federal employees have a pension and are taking TSP distributions during retirement, many of them will surpass the combined income limits.
Here are the combined income thresholds for 2021:
If your combined income is less than $25,000 ($32,000 for married couples filing a joint return), your Social Security benefits are tax-free.
If your combined income is between $25,000 and $34,000 ($32,000 and $44,000 for joint filers), then up to 50% of your benefits are taxable.
If your combined income is more than $34,000 ($44,000 for joint filers), then up to 85% of your benefits are taxable.
To determine your combined income, take your modified adjusted gross income, add 50% of your Social Security benefits for the year, and add all tax-exempt interest income, such as interest received on municipal bonds.
Understanding how your federal retirement benefits will be taxed is critical to the longevity of your financial plan. And by taking the time to plan early, you’ll not only ensure you have the income you need in retirement but will also have more opportunities to minimize taxes. Although we reviewed how your benefits are taxed at the federal level, depending on where you live, you may also have to consider state income taxes. Lastly, consult with a qualified financial planner if you don’t feel confident in creating your financial plan or want a professional opinion.
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2023 Legislative Change Notice
The SECURE ACT 2.0 passed and impacted many of the articles on this website. While the articles were correct when written, it’s impossible to re-write every article. Please consult a qualified professional (i.e., CFP®, CPA, or attorney) before implementing any strategy.