As federal employees approach retirement, thoughts shift from worry over the workday grind to concerns about preparing for retirement. And while you will likely never starve due to your pension and Social Security, many mistakes can devastate your retirement, turning your vision of a fulfilling second chapter into a period of scarcity and fear. So, to help you plan, I’ve compiled the following list of the three critical mistakes I often see federal employees make before they work with my firm, along with tips for how you can potentially avoid making these same mistakes.
1. Forgetting Beneficiary Designations
One of the most common mistakes that I see, and ironically one of the easiest to avoid, is naming and updating beneficiary designations. Yes, this sounds simple, but you may not realize how many beneficiary designations you have. Because it’s easy to lose track of the number of designations, it’s easy to not assign or update them as life changes.
What Happens When No Beneficiary Is Named?
If there is no beneficiary on file for your federal employee benefits, each program will follow what’s called the order of precedence. This means your assets in each program (FERS refund, TSP, FEGLI, last paycheck) will be distributed in the following manner:
- A surviving spouse, if none then,
- Children (equal shares), if deceased their share distributed to their children if none living then,
- Parents, if none living then,
- Executor or administrator of the estate, if none then,
- Next of kin following the laws of the state of residency.
Now for your nonfederal employee accounts (IRAs, checking and saving, etc.), your assets will be distributed via the probate process for your state. Probate is the court-supervised process that determines the appropriate distribution of assets with no valid beneficiary designation. If you have a will, the courts will generally distribute the assets according to the document. However, if you die intestate (with no will), the state has its order of precedence for distributing assets.
Why avoid probate? Well, the probate process can be costly, about 2-4 percent of the estate in California. So, for instance, if the value of your estate is $500,000, your probate fees could be $20,000! Yes, your heirs would have to pay a $20,000 fee that could have been easily reduced or eliminated by having a beneficiary designation on all your accounts. Not to mention that probate can and often is a lengthy process, taking anywhere from 6 to 18 months to distribute assets.
However, remember that assets only go through probate if they do not have a valid beneficiary designation at the time of your death. Meaning, you can avoid probate by ensuring all your accounts have a beneficiary designation. It’s worth noting that trust are also a common tool used to avoid probate but can come with a significant price tag.
Tip: Contact your HR and ask for copies of all four of your beneficiary designations. If you don’t have a beneficiary designated, assign one.
Keeping Them Current
Since your beneficiary designations play such a significant role in your estate plan, it’s imperative that you review them regularly to ensure they are up to date. This is especially important after certain life events, such as marriage, divorce, births, or deaths. Contrary to popular belief, beneficiary forms are not automatically updated when completing new enrollment paperwork. So, your original designation will remain in force until you submit another form to cancel or change your designations.
Another reason why it’s essential to review your designations regularly, even if no change has occurred, is because forms get lost or misfiled. So, by checking your designations regularly, you’ll eliminate any chance that they are not exactly as you wish.
Tip: Create a beneficiary designation spreadsheet listing all four of your federal program and nonfederal accounts and include the primary and contingent beneficiaries designated. Review this document every 1 to 3 years or whenever there is a significant life event, such as marriage, divorce, birth, death, or a substantial change in your financial situation
Get It Done!
Because reviewing beneficiary designations is so essential, it’s one of the first areas that I review for my financial planning clients. And although designations don’t change frequently, I want to ensure that there are no mistakes.
So, if you have not designated a beneficiary or don’t remember who you designated, then it’s time to take care of it. The good news is that naming a beneficiary is easy. If you don’t remember who you named as a beneficiary, you can submit a new form that automatically cancels any designation on file. To designate a beneficiary for your pension refund, you’ll complete the SF-3102. For unpaid compensation, you’ll complete SF-1152. For your TSP beneficiary, you’ll use TSP Form 3 and for FEGLI, complete the SF-2823.
2. Not Preparing For A Pension Check Delay
Before you retire, you should tighten up any financial loose ends that add additional risk to your financial future. An emergency fund is especially critical as you enter retirement since there will be some uncertainty about when you’ll receive your full FERS pension check. Although you’ll receive your last paycheck and a lump sum payment for annual leave, usually within the first few weeks after your retirement, it can take 3-6 months to receive your first regular pension payment. So having some extra cash in hand is critical during your transition from federal employee to retiree.
How much savings do you need? The short answer is 3-6 months’ worth of non-discretionary living expenses. The long answer is, it depends on your situation; some factors include your family’s unique needs (health or lifestyle) and your risk tolerance (what amount will help you sleep at night?). Because of the uncertainty surrounding when you’ll receive your first pension payment, it might make sense to be more conservative and save six to nine months’ worth of living expenses.
3. Planning Your Retirement With Your Gross Pension
When planning your federal retirement, you’ll need to calculate your FERS pension and should request an estimate from your HR. But often, these projections don’t represent what will actually be deposited into your bank account. The reason for this discrepancy is that most individuals calculate their gross pension, not their net pension, and even your pension estimate may not include all the deductions that should be considered. Knowing the difference between your gross pension and your net pension is critical since your retirement income is based on your net pension, and overestimating your pension could mean a cash shortfall in retirement. So, let’s review the most common deduction you should consider when calculating your net pension.
The Survivor Annuity Cost
When you retire, you’ll have the option of providing a survivor annuity for your beneficiaries (aka the Survivor Benefit). This benefit allows your spouse or someone with an insurable interest (depends on you financially) to receive a portion of your pension every month after you die. However, this benefit is not a free lunch and, if elected, will permanently reduce your pension. The amount of the reduction depends on the survivor annuity you choose. If you select the full survivor benefit, which provides your survivor with 50% of your unreduced monthly pension for the rest of their life, your pension will be permanently reduced by 10%. Whereas if you elect the reduced survivor benefit, your survivor will only receive 25% of your unreduced monthly benefit, but your pension will suffer a smaller reduction of 5%. Your pension estimate will generally include this deduction when projecting your FERS pension; however, if you perform your calculation, make sure you deduct this cost from your gross pension.
Many federal employees don’t realize that about 95-99% of their 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. So, taxes will significantly impact your retirement income and must be considered. Most federal employees I have worked with pay an effective rate* between 15-20%, but everyone’s situation is different. Also, depending on your state, you may need to include state income tax when calculating your net pension.
*The percentage of your income paid in taxes.
Maintaining your Federal Employees Health Benefit (FEHB) coverage in retirement can help keep your medical cost from skyrocketing during a period when you’ll likely need more health care services. Although you’ll probably see a slight increase in your FEHB premiums since you’ll be paying on an after-tax basis, you shouldn’t see a significant difference from what you were paying before you retired. But you’ll have to remember to factor in the FEHB premiums when calculating your net pension.
Putting It All Together
Now let’s look at an example of how your gross pension can be very different from your net pension. For our example, we’ll look at our favorite fed Bob:
As you can see from this example, the net pension was nearly 50% of the gross pension. While everyone’s situation is unique, this example makes it clear that planning your retirement using your gross pension can result in a significant cash flow problem. On the bright side, some deductions will disappear in retirement (at least from your pension, that is), such as the Social Security tax, Medicare tax, TSP contributions, and FERS contributions.
The road to financial independence is full of twists and turns and requires plenty of planning. Since the stakes couldn’t be higher, ensure you read, re-read and then take the necessary action to avoid making the three mistakes covered. Finally, having a personalized plan will be essential to preventing costly mistakes. So, if you’re not confident in creating your financial plan or want a professional opinion, consult with a qualified financial planner.
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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.