This is the second of a 2-part article on taxes in retirement. This article will talk about taxes on benefits paid by sources other than OPM (like Social Security, Federal Employees Health Benefits and the Thrift Savings Plan). To read part 1 of this article, CLICK HERE.
No doubt, taxes can become a complicated topic very quickly. Having a clearer understanding of how taxes are applied – and when – can help you to formulate a strategy to not pay any more taxes than absolutely necessary! Let’s start with our first topic, Social Security.
To really understand how Social Security benefits are taxed, you have to look at both the federal and the state level.
At the federal level
At the federal level, the Social Security benefit you receive is going to be taxed. Generally speaking, roughly 85% of the benefit that someone receives from Social Security is taxable.
Given the level of income that federal retirees are going to have with their pension, they can pretty much bank on 85% of their Social Security benefit being taxed. Out in the private sector, there are ways to get out of being taxed on Social Security, but it takes a lot of tax planning to do so. On the other hand, given the fact that the federal pension is taxed at the federal level, federal retirees can’t avoid Social Security being taxed at the federal level.
At the state level
While most states do NOT tax Social Security, there are 13 states that DO. They are: Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont and West Virginia. To be clear, this is not a reason to move to or move out of a given state. It is simply something that needs to be considered in the equation so that there are no tax surprises when someone begins drawing their Social Security.
Federal Employees Health Benefits (FEHB) Program
When you are still working and are enrolled in one of the FEHB programs, you pay your premiums with pre-tax money. This is money that has not been taxed yet that is taken out of your paycheck and goes directly to the carrier (whether it is Blue Cross, Aetna, Kaiser or any of the FEHB plans that are out there). This is a wonderful tax advantage for federal employees – but only while they are working.
Once you step into retirement, those premiums are no longer paid with pre-tax money. Now, they are paid with after-tax money. For example, if you are enrolled in the high Blue Cross Blue Shield “Self Plus One” plan for you and your spouse, your premium is around $7,500 a year. In order to pay that $7,500, all you would need is $7,500 because you do not need to pay the tax on that money before you pay it to Blue Cross Blue Shield. You simply receive the bi-weekly equivalent of the $7,500, but it is not reported as income to you for that year.
However, if that same program was in place in retirement, all of that money is now going to be taxable to you. Therefore, in order to pay Blue Cross $7,500, you probably need to start with roughly $9,500 (depending on your tax bracket). This is true because you now have a tax obligation on that money that you did not have while you were still working.
Many retirees are not prepared for this shift in tax obligation. All in all, federal retirees must be prepared to not only set aside more money to pay the normal FEHB premiums that continue to rise in retirement, but they must also be prepared to pay tax on that money when they receive it (before handing it over to the FEHB carrier).
Thrift Savings Plan (TSP)
Most employees know that there are taxes due on the back end of the Traditional TSP. This is true because the employee did not pay tax when they put the money into their account while working. There is still a lot of misinformation about how this actually works, so let me explain the two different tax sides of the Thrift Savings Plan.
The Traditional TSP is paid with pre-tax money. It is actually called “tax-deferred” meaning you are going to pay taxes later when you take the money out of TSP. Again, tax advantage today, but still have to pay the tax later.
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 $250,000. The principal (the $100,000 that you originally contributed) was not taxed, so you now have an obligation on that $100,000 on the back end when you take the money out.
What many federal employees do not understand is that they also owe the tax on all of the growth when they take a distribution (or payment) out of the TSP.
If you were to take the entire $250,000 (either all at once or over a long period of time), you will owe the tax on the whole amount — not just the money you put in, but all of the growth as well. In our example, you wouldn’t just owe tax on the $100,000 principal, but the $150,000 of growth, too.
The Roth TSP was created in 2012. If a participant chooses to do so, they pay into the Roth TSP with after-tax money. You do not receive an immediate tax advantage with the Roth TSP (like you do the Traditional TSP). You pay the tax along the way as you contribute to the Roth TSP.
Using the same example as before, let’s say you contribute $100,000 into the Roth TSP. Remember, you have already paid the tax on the $100,000 you contributed. If that account grows to $250,000 and you go to take the money out in retirement, you do not pay tax on any of it — neither the principal nor the growth.
There is an argument to be had for both the Traditional and the Roth TSP — a they each have their advantages. The point is to recognize what your tax obligations are today and what the consequences are going to be later.
Required Minimum Distributions (“RMDs”)
The other element that is worth mentioning is Required Minimum Distributions or “RMDs.” Eventually, the government wants their tax on the money that is in your TSP (and other accounts like a Traditional IRA).
Around the age of 72, the IRS requires that you start taking some of this money out, so that you can pay the tax on it. RMDs happen even out in the private sector with Traditional IRAs that are taxed just like the Traditional TSP. Essentially, the rules say that by the time you get around that age, you will need to take a certain percentage of your account each and every year, so that you can pay the tax on it. That percentage goes up every year as you get older and is based on the account balance at the end of the prior year.
However, in the private sector, Roth IRAs are not subject to a Required Minimum Distribution. Meaning, that Roth IRA account that is growing tax-free, can just keep growing and growing and not ever have a time that you must start taking withdrawals out of it. That is why the Roth IRA in the private sector is viewed as a multi-generational program – meaning you can pass it on to your children and it can continue to grow tax-free beyond your lifetime.
Unfortunately, with the TSP, the Required Minimum Distribution is across the entire account, even if there is a Roth portion of the account. That makes this Roth TSP option so much less attractive from what it was really intended to do, which is to create two different tax buckets to withdraw the money from. Of course, the more a retiree takes out of the TSP, specifically the Traditional side of TSP, the more likely it is that they are back up in that higher tax bracket because they are taking more income that will be fully-taxable.
The TSP has a variety of ways that employees can take money out in retirement. Based on those different decisions, that will ultimately determine how the beneficiaries may receive the money. The big takeaway here is that regardless, Uncle Sam is going to get his money, either from the retiree while they are living or from the beneficiaries. Someone is going to have to pay the tax on it. The money in Traditional TSP has not been taxed yet, so taxes are due from someone.
TSP Beneficiary Account
The most common beneficiary designation for the TSP is your spouse. However, this can lead to a tremendous tax obligation later. If you are retired and you have named your spouse as the beneficiary on the TSP and you die, your spouse can choose either for the money to be transferred to a special IRA in the private sector (called a “Spousal Inherited IRA”), or leave the money in the TSP in a special account called a “Beneficiary TSP” account.
If they choose the Beneficiary TSP, the money is still in the TSP, and the spouse can decide what funds to be invested in, but the spouse is not allowed to contribute any more money into the account.
In either case – with a Spousal IRA or Beneficiary TSP account – the spouse is likely to (and should) name a new beneficiary in the event of their death.
However, if the spouse were to leave the money in a Beneficiary TSP account and name the children as the new beneficiaries, something odd happens that does NOT happen in a Spousal Inherited IRA. When the spouse dies, the children receive the TSP money, but it must immediately be paid in cash all at one time. To make matters worse, the Traditional balance is fully-taxable to the children.
For example, if there is $600,000 in the Traditional TSP and it is supposed to go to three different children, each one of them is going to get $200,000. That amount is going to be taxed in the current tax year — all at one time. If an adult child making $75,000 a year is used to being in that tax bracket, and then suddenly in one year, it looks like they made $275,000 of income, they are going to pay an extraordinary amount of tax on that money.
With the Beneficiary TSP account (upon the death of the spouse who inherited it), the beneficiaries are not permitted to withdraw a little bit at a time. This results in a big tax blow that most employees and spouses do not even think about in the planning process.
Within the TSP, there is not a solution to this particular problem – that’s simply the way the Beneficiary TSP program is structured. When the spouse passes, the money must be distributed to whomever is named as the beneficiaries and it is all taxed in the current year.
But in that same scenario, if you were out in the private sector, and named your spouse as the beneficiary, your spouse could transfer the TSP into a “Spousal Inherited IRA”. If your spouse named your children as the beneficiaries to that IRA, upon the death of your spouse, your children can put the money into what is called a “Non-Spousal Inherited IRA”, which essentially allows them to spread out the payments that they would receive over many years, so that they do not have that immediate tax consequence all at one time.
It is for these reasons that it is very important that your spouse be involved in these planning conversations. If your spouse has no idea of the consequences to their decision to leave the money in the TSP and name the children as the beneficiaries, how will they know to do anything different?
My best advice with respect to taxes is to recognize that they are very real in retirement. I refer to them as the “carbon monoxide” that can kill an otherwise really good financial plan. You must have some very serious conversations about taxes, and it starts with having those conversations with yourself. Take the time to work with your tax professional or financial planner and put a tax strategy in place.