Federal employees and retirees will encounter taxes on benefits they receive spanning Social Security, annuities, insurance premiums and health savings accounts.
Taxes on FERS and CSRS Annuity
A retiree’s basic annuity is funded at least in part by contributions made to the relevant retirement system while employed. When a retiree begins receiving a monthly annuity, he or she is entitled to exclude the portion of the monthly benefit that is attributable to the retiree’s after-tax contributions to the relevant retirement system. The rules used to determine how the taxable portion of a retiree’s annuity is computed have changed over the years.
The IRS uses a “simplified method” that calculates the tax-free portion of the monthly annuity by dividing the total investment by the number of monthly payments. When initially adopted in 1987, use of this method was optional but it is mandatory for persons retiring after November 30, 1997.
The total investment is the amount contributed to either CSRS or FERS (or both) on an after-tax basis during employment. This information is provided to the retiree by OPM a short time after separation and also is shown on IRS Form 1099-R issued to the retiree by OPM in January of each year.
The number of monthly payments depends upon whether the retiree elects to provide a survivor annuity. If the retiree does not elect a survivor annuity, the table below will be used to determine the number of monthly payments used in the formula.
Age of Retiree | Number of Payments:
55 and under | 360
56–60 | 310
61–65 | 260
66–70 | 210
71 and over | 160
If the retiree elects a survivor annuity, the number of months used is computed by reference to the combined ages of the retiree and the person who will receive the survivor annuity. The following figures are used:
Combined Age of Annuitants | Number of Payments:
Not more than 110 | 410
111 to 120 | 360
121 to 130 | 310
131 to 140 | 260
more than 140 | 210
The above figures that show the number of monthly payments the retiree will receive apply regardless of the state of his or her health or whether a survivor annuity is elected.
Computation of the excludable portion of the annuity payments may be illustrated by the following example:
Mary Henderson is a retired federal employee who made total contributions of $75,000 to the CSRS during her government service. She retired at age 59 in April 2000 and did not elect to provide a survivor annuity. Under the above formula Mary is entitled to exclude $241.94 out of each monthly annuity check (i.e., $75,000 ÷ 310 = $241.94). If she receives 12 annuity checks during the tax year, she may exclude a total of $2,903 (i.e., $241.94 x 12 = $2,903).
Once the excludable amount is determined, it remains the same until the retiree has fully recovered the after-tax contributions to the retirement system. The retiree is entitled to exclude a portion of the monthly annuity until all after-tax contributions to the retirement system have been recovered. Thereafter, all annuity payments are fully taxable.
Payment of Taxes on Benefits
All taxpayers must pay at least 90 percent of their total federal income taxes through withholding or estimated tax payments. Retirees have the option of having federal income tax (and certain state income taxes) withheld from their annuities. A good money manager may wish to elect to pay federal income taxes through estimated tax payments.
If you do not elect withholding on your annuity, you must make quarterly estimated tax payments.
A taxpayer who fails to pay at least 90 percent of the total tax due either through withholding or estimated tax payments may be liable for an estimated tax penalty. The amount of the penalty is equal to the interest that would accrue for the period of the underpayment. Interest rates vary and are adjusted quarterly.
Interest on tax liabilities is compounded daily. A person who fails to pay at least 90 percent of his or her tax liability through a combination of withholding and estimated taxes may determine the amount of the estimated tax penalty, if any, by completing IRS Form 2210 and attaching it to the tax return.
The rules for computing and paying estimated taxes and any relevant penalties are discussed in IRS Publication 17, Your Federal Tax. All tax forms may be obtained by calling (800) 829-3676 or online at www.irs.gov.
State tax treatment of federal annuities
Each state has its own tax code, which determines whether your federal annuity is taxable and, if so, to what degree. If your state does tax federal annuities, you may want to enroll in the State Income Tax Withholding Program.
For states that have a personal income tax, treatment of federal retirement benefits varies widely. Some states offer partial exemptions by income level, for example excluding the first several thousand dollars of annuity from state taxation. Some offer partial exemptions by age, for example treating annuitants over age 62, 65 or some other age more leniently. Others make special provisions for disability annuities or for annuities earned before a certain date.
These state tax policies change continually. Check with your state’s tax department for the latest information on how your state treats federal retirement benefits.
Some states have agreements with OPM under which you can arrange to have taxes withheld from your annuity. The amount is up to you. To check on your state’s status or to start, stop or change your income tax withholding in any of the participating jurisdictions after you retire, call OPM’s Annuitant Express at (800) 409-6528 and follow the directions given on the menu.
Tax Treatment of Federal Insurance Premiums
Employees of all executive branch agencies and the U.S. Postal Service are eligible to pay their Federal Employees Health Benefits premiums with pre-tax dollars. This is called a health insurance “premium conversion plan” in which the employee’s taxable income is reduced by the amount of health insurance premiums the employee would otherwise have to pay. It produces savings on federal, Social Security, Medicare and, if applicable, state and local income taxes.
Participation is automatic unless waived; there are no open seasons and no forms to fill out. One potential reason for opting out is that premium conversion may reduce the base for Social Security benefits. Also, tax law imposes certain limitations that may affect some employees who expect to change plans during a calendar year.
Similar tax policies apply under the Federal Dental and Vision Insurance Program except that premium conversion is mandatory for active employees in FEDVIP.
Generally, retirees are ineligible for premium conversion because of tax code provisions, however, certain federal retirees are eligible to at least partly pay FEHB premiums and/or Federal Long Term Care Insurance premiums with pre-tax money under the 2006 Pension Protection Act. OPM in benefits administration letter 07-201 of June 20, 2007, stated that federal retirees deemed to be retired “public safety officers” under the 2006 act are eligible to pay up to $3,000 a year in health and long-term care insurance premiums with pre-tax money, so long as the distribution is made directly from the retirement system to the provider—as is commonly done with retiree FEHB and FLTCIP premiums.
“Public safety officers” for this purpose include law enforcement officers and firefighters, under the law. Other retirees are not eligible. Said the OPM letter, “Retired public safety officers are deemed to have made a premium conversion election for this purpose. As a result, retired public safety officers whose CSRS or FERS annuity payments include a direct premium payment to a health insurance carrier or long term care insurance carrier may self-identify eligibility for, and self-report, the tax exclusion” to the IRS in their tax filings. Since this is an IRS law, OPM cannot determine whether an individual meets this definition, OPM said. Potentially affected individuals should check IRS Publication 721, Tax Guide to U.S. Civil Service Retirement Benefits. That publication states that “the CSRS and FERS are considered eligible retirement plans.”
Tax Treatment of Health Savings Accounts / Health Reimbursement Arrangements
A health savings account is a trust account that you own for the purpose of paying qualified medical expenses for yourself, your spouse, and your dependents. Interest earned on your account is tax-free and tax-free withdrawals may be made for qualified medical expenses (see IRS Publication 502). You may withdraw money from your HSA for items other than qualified health expenses, but it will be subject to income tax and if you are under 65 years old, an additional 10 percent tax penalty on the amount withdrawn. Voluntary contributions are tax deductible.
For health reimbursement arrangements, tax-free withdrawals for qualified medical expenses similarly are allowed. HRA accounts do not earn interest, the funds cannot be used for non-medical expenses and voluntary contributions are not allowed.
Tax Treatment of Flexible Spending Accounts
Flexible spending accounts were made available to all executive branch employees effective in July 2003. Prior to that, such accounts were available only to employees of the U.S. Postal Service and certain smaller agencies, mostly in the financial regulatory field.
Employees who elect to participate set aside an annual amount of salary to be contributed to their FSA. The agency deducts these contributions from the employees’ pay throughout the plan year. Under Section 125 of the Internal Revenue Code, participants do not pay employment taxes on these allotments.
Tax Treatment of Social Security Payments
If you begin receiving a Social Security benefit, whether you will have to pay federal taxes on it and, if so, how much, depends on your total income.
Taxable Social Security benefits include monthly survivor and disability benefits. They do not include Supplemental Security Income (SSI) payments, which are not taxable. Critical information for determining tax liability is contained on Form SSA-1099, which you should receive early each year from SSA for any year you received benefits. If you are receiving Social Security benefits from more than one source (for example, on your own account and based on another person’s earnings) you will receive a Form SSA-1099 for each.
To find out whether any of your benefits are taxable, compare the “base amount” (see below) for your filing status with the total of:
- one-half of your benefits; plus
- all your other income, including tax-exempt interest.
When making this comparison, do not reduce your income by any exclusions for:
- interest from qualified U.S. savings bonds;
- employer-provided adoption benefits;
- foreign earned income or foreign housing; or
- income earned in American Samoa or Puerto Rico by bona fide residents.
If the total income is more than your base amount, part of your benefits is taxable.
If you are married and file a joint return, you and your spouse must combine your incomes and your benefits to figure whether any of your combined benefits are taxable. Even if your spouse did not receive any benefits, you must add your spouse’s income to yours to figure whether any of your benefits are taxable.
Your base amount is:
- $25,000 if you are single, head of household, or qualifying widow(er);
- $25,000 if you are married filing separately and lived apart from your spouse for all of the year;
- $32,000 if you are married filing jointly; or
- $0 if you are married filing separately and lived with your spouse at any time during the year.
If part of your benefits is taxable, how much is taxable depends on the total amount of your benefits and other income. Generally, the higher that total amount, the greater the taxable part of your benefits.
The taxable part of your benefits usually cannot be more than 50 percent. However, up to 85 percent of your benefits can be taxable, if either of the following situations applies to you:
- the total of one-half of your benefits and all your other income is more than $34,000 ($44,000 if you are married filing jointly); or
- you are married filing separately and lived with your spouse at any time during the year.
The IRS publishes instructions on how to determine your liability in each year’s 1040 Forms and Instructions booklet. IRS publications 554 and 915 also are helpful.
Taxes on TSP Distributions
In “traditional” Thrift Savings Plan balances, employee investments (and employer contributions, for employees under the Federal Employees Retirement System) are made with pretax funds, with that money along with its associated earnings taxable on withdrawal. The rate of tax will depend on the recipients’ tax bracket at the time the withdrawal is made.
In Roth balances, employee investments are made on an after-tax basis but are withdrawn tax-free. The associated earnings on Roth investments also are tax-free if certain conditions are met: the withdrawal is made at least five years after the beginning of the year in which the first Roth investment was made; and the participant is at least 59 ½ years old, disabled or deceased. For this purpose, “disability” uses the definition in Section 72(m)(7) of the Internal Revenue Code of being “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.” This differs from the definitions of disability under the federal retirement, Social Security and federal employee injury compensation programs. See Roth Balances.
Employees can invest through either or both types of balances, up to annual dollar limits for combined investments.
Regardless of whether the investor’s personal investment was made with pretax or after-tax money, any government contributions and the associated earnings for FERS employees are made in traditional balances and are taxable when withdrawn from the TSP.
A TSP participant may borrow money for his or her account. There are no tax consequences when the money is borrowed. A participant who has both traditional and Roth balances will have the loan drawn proportionately from each type of balance, and loan repayments will go back into each type of balance proportionately.
If the TSP participant has not repaid the full amount of the loan either prior to separation from service or within 60 days after separation, the portion of the outstanding balance on the loan attributable to a traditional balance is treated as a taxable distribution unless it is repaid. The portion attributable to any Roth investments is not taxable but the portion attributable to earnings on Roth investments will be taxable if the conditions described above are not met.
Transfer to IRAs
A distribution from the TSP qualifies for a direct transfer or a rollover into an IRA. A direct transfer avoids problems that can arise in a rollover, in which the money is paid directly to the participant who then must in turn deposit it into an IRA. Unless a payment is made directly to the trustee of an IRA, the TSP is required to withhold 20 percent of any payment as income tax withholding and pay it to the IRS. The individual would then have to deposit an equivalent amount into the IRA and claim a tax refund.
If a participant has both traditional and Roth balances, separate transactions must be ordered for each type of balance. A Roth balance can be moved out of the TSP only through a direct transfer, not through a rollover.
Income Averaging of TSP Lump-Sum Distributions
In certain limited circumstances, the tax on a lump-sum distribution from the TSP may be computed by using either five or ten year income averaging. A lump sum distribution is defined as a distribution of the entire balance in the account. If an individual qualifies for ten year averaging, this may significantly reduce the taxes owed on the distribution.
A TSP participant must satisfy all of the following requirements to qualify for income averaging:
- The distribution must represent the entire balance in the participants’ account.
- No portion of the distribution may be rolled over into an IRA.
- The distribution must have been made because of the participant’s death, separation from service or after the recipient has attained the age of 591⁄2.
- The recipient of the distribution must elect to compute the tax on the entire portion of the distribution by using income averaging.
- The recipient must have been born prior to January 1, 1936 to use ten year averaging.
A lump-sum recipient born after January 1, 1936 may only use five year averaging. However, the right to use five year averaging is only available for distributions received on or before December 31, 1999.
If all of these requirements are satisfied, the recipient of the distribution may use special tax rate tables to compute the tax due on the distribution. The special tax rate tables for computing the tax due using either five or ten year averaging may be found in the instructions that accompany IRS Form 4872, the form used to report the tax on a lump-sum distribution.
The minimum distribution penalty is designed to insure that a person who has been saving in a tax-deferred plan (TSP, IRA or other similar tax-deferred arrangement) is compelled to start taking distributions from the plan beginning at age 70 1⁄2. IRS rules require certain minimum distributions effective April 1 of that year, based on your account balance and age. These distributions cannot be transferred to an IRA or similar tax deferred plan. Thus, if you are having monthly payments from the TSP into an IRA, at that point the payments will be adjusted so that at least the minimum distribution from a traditional, taxable balance goes directly to you in a taxable way.
This requirement applies both to money invested through the TSP’s traditional design and through the Roth design. The distributions must be made proportionately from traditional and Roth balances, for investors who have both. (Note: The requirement for minimum distributions of Roth balances might be avoided by having that balance transferred to a Roth IRA; consult a tax adviser.)
Failure to take a required distribution will result in a 50 percent penalty on the amount that should have been withdrawn. (If an individual remains employed by the federal government after reaching age 701⁄2, the minimum distribution rules do not apply to funds in the TSP, but do apply to funds held in other tax-deferred plans such as an IRA.)
The first minimum distribution must be taken by not later than April 1 of the year following the year the participant reaches age 70 1⁄2. A minimum distribution must be taken for all subsequent years by not later than December 31. If a person waits until April 1 of the year after reaching age 70 1⁄2 to take a minimum distribution, the participant will be required to take two minimum distributions in the same year, the distribution for the year in which he or she attained age 70 1⁄2 and the minimum distribution for the following year.
The amount of a minimum distribution is determined by dividing the aggregate balance in all of the taxpayer’s tax-deferred plans (i.e. all IRAs and the TSP) by the taxpayer’s life expectancy (or the joint life expectancy of the taxpayer and his or her beneficiary). All qualified plans are combined for purposes of applying the minimum distribution rules. Life expectancy may be determined by consulting the life expectance tables found in IRS Publication 590 at www.irs.gov.
If a person fails to take a minimum distribution, he or she is subject to a penalty equal to 50 percent of the amount by which the minimum distribution exceeds the amount actually distributed.
IRS Publication 590 includes a detailed explanation of the minimum distribution rules.
Distributions Payable at Death
If you are the spouse beneficiary of a decedent’s TSP account, you have the option of leaving the death benefit payment in a TSP account in your own name (a beneficiary participant account). The amounts in the beneficiary participant account are neither taxable nor reportable until you choose to make a withdrawal, or otherwise receive a distribution from the account. Beneficiaries other than spouses must withdraw the account.
Distributions are taxable to the recipient as ordinary income in the year funds are withdrawn from the account. If a participant’s spouse is the beneficiary of the TSP or an IRA, he or she may make a tax-free rollover of this amount into his or her IRA. If a person other than a spouse is the beneficiary, and the participant has started to take minimum distributions, the beneficiary must continue to make withdrawals at least as rapidly as the participant had done prior to death.
Long Term Care Insurance
The Federal Long Term Care Insurance Program is designed to be a “tax-qualified plan” under the tax code. This means that:
- benefits are not taxable; and
- you can deduct long-term care insurance premiums as medical expenses to the extent that your total qualified medical expenses exceed 10 percent of your annual adjusted gross income. The amount of the deduction is also subject to other IRS limits by age.
FLTCIP premiums cannot be paid from pre-tax money.
Some states provide favorable tax treatment of long-term care insurance premiums. Check with your state tax department for details.