Delivered on: Wednesday, March 16, 2022

Taxes for Federal Retirees

An eye-opening view to reframe your outlook on taxes after you retire

• TAX BRACKETS: Why most employees feel they will be in a lower tax bracket in retirement
• BENEFITS: Changes to the taxability of your CSRS/FERS pension, Survivor Benefits, FEHB premiums, Social Security benefits and income from the TSP
• STATES: Review of retiree-friendly states and the effect this has on each of your benefits

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Prefer to read instead? Below is a transcript from the video:

Welcome to today’s webinar on Taxes for Federal Retirees. I’m going to warn you, this is a monster topic that’s going to take us a while to get through. I normally like to keep these sessions 30 to 60 minutes, no promises today, because there is just so much to share with you on the tax situation that you’re facing as a retiree, that I want to be able to get through all of those salient points. And so if you’re not able to stick on with us the whole time today live, then of course you’re going to have access to the replay and be able to go back through to listen to any parts again that you might need a second pass, and of course, pick up any topics that you might have missed just because of how long this session actually is.

I’m going to get through it as succinctly as I can, but there’s a lot to cover. Quick housekeeping items like we always do: Today’s topic of course is a really important one. I knew that this was going to be a great topic to discuss because we did a podcast on this topic as well. It was our top downloaded podcast of all time. And so, I know you are curious about taxes and what that means for you in retirement. Like we always to do on our webinars, we do want to make sure that you have an opportunity to ask your questions and get your answers. I’m going to stay focused on delivering today’s material, but our support team is standing by in the Q&A area to answer your questions via the chat.

Feel free to submit a question there. All that I ask is that it’s about this topic, so that they’re able to get through as many of these questions as possible today. Like we always do, handouts are available. You can either download them right by that Q&A area in the webinar portal. You’ll see a little red dot for handouts. So, you can go there and go ahead and download it. If you forget, no problem, the handouts will be emailed to you. So, you’ll have them for your reference. You can also look to the very bottom of your screen, and there’s a link to the handouts there as well.

We always record these sessions. So, you will get a link to the replay following today’s session. If you need to go back and re-listen to it, if you need your spouse to listen to it, if you’ve got some buddies at work that need to hear this, you can send that link over to them as well. I normally say stay till the end, because I’ve got some cool, juicy, salient point that I want to share with you. That’s pretty much all of today’s material. But one of the number one questions that we get about TSP in retirement is going to be answered here at the end of today’s session. I want all of your ears perked up because it is something that will affect the vast majority of you and we want to make sure that you have it right.

I’m Chris Kowalik, you know me, founder of ProFeds. We’re really delighted to be able to do these webinars. Luckily, we’ve got quite a number of different ways that we’re able to interact with Feds, whether it’s on webinars like this or through our workshop or our podcast. If you’re a podcast listener, just search for FedImpact, you’ll find us. Love to have you here, and our message over there as well. Again, our support team is standing by for your questions, so throw those in the Q&A area.

Today’s topic is all about Taxes for Federal Retirees. This is an eye-opening view to re-frame your outlook on taxes after you retire. You’re not just stuck with the tax situation that the government has given you. You have a lot of choices, and there are quite a number of areas that I think a lot of federal employees overlook and think they have no control over when in fact they do. We’re going to talk about a lot of those areas today. For our agenda, of course, we’re going to be talking about tax brackets. We need to have a general sense of how those work. I’ll answer the question that so many people ask us was, aren’t I going to be in a lower tax bracket when I retire? Why are we so much about taxes? We’re going to debunk that here shortly.

Next, we’re going to talk about all of the benefits that you have and the taxability of those benefits. We’ve got a long list of those. Of course, we’re not just talking about federal taxes, we’re also talking about state taxes as well. There are some retiree friendly states, some that aren’t so friendly and you might know which those are, but we want to make sure that you’re clear. Before we jump into the meat of today’s webinar, I have to talk about what this session will not cover. We are not here to give you tax advice. We want to give you some tax awareness, so that you have a better sense of the things that you need to be investigating and putting into action for yourself, so you can live the retirement that you want.

We’re not going to be able to cover every single aspect of the tax issues that you’re going to experience in retirement. What we’re going to cover today are the highlights of your federal benefits. We have absolutely zero clue what your tax situation looks like, so please seek professional help to execute a tax strategy that suits you. When you learn about things here and you say, whoa, I didn’t realize I had some control over that, what should I do? That’s when you seek a professional to be able to do that.

Let’s talk about taxes in general. Taxes are a very real part of retirement, and it should also be a very real part of financial planning. Taxes aren’t something that just happened to you. We have a say in what that’s going to look like later in retirement. But ignoring this tax monster doesn’t make it go away. Just pretending that taxes won’t matter, won’t make it so in retirement. It’s important that you realize that not all money is taxed in the same way, and it’s not all taxed at the same time. So, understand when things are taxed and at what level will help you to realize that there really is a strategy to all of this.

So, speaking of strategies, the most successful retirees have a solid tax strategy. They need to have that in place to make sure that they don’t pay more tax than is absolutely necessary. Isn’t that the goal? We’re not trying to get out of taxes that we legitimately owe. We’re simply trying to use the tax code and all of the features in it to put ourselves in the very best situation and not pay more tax than is absolutely necessary. Today’s session on taxes is going to highlight all of the benefits that you see on the screen here today. These are all of the normal benefits that we cover in our retirement workshop.

We are not going to go into depth on how to calculate these and the different features of these benefits, but simply the taxability of each of these items. Let’s first start talking about tax brackets. We often hear, I’m pretty sure I’m going to be in a lower tax bracket when I retire. So why are we worrying so much about taxes? Well, we first have to understand how tax brackets work. In the United States we have a progressive tax system. That essentially means the tax rate, the percentage that you pay, increases as your taxable amount out increases.

In layman’s terms, the more money you make, the more tax you pay, percentage wise. That word progressive isn’t a political term. It simply refers to the way that tax progresses from low to high. The result of a progressive tax bracket or tax system, as opposed to a flat tax system, is that the taxpayer’s average tax, that is the amount that they paid, divided by the amount that they earned, is less than the person’s marginal tax rate or their bracket.

Let’s take a look at the bracket itself, and then we’ll see some of this in action, so that you have a better sense of really how this works. This might be review for some of you and that’s okay, but we want to level the playing field here. Right now, we have seven tax brackets. Ranging from 10% all the way to 37%. Each of those brackets have four different filing statuses. So, where you fall into that bracket, that 10%, 12%, 22% and so on, is largely determined by which filing status you are taking, single, married, filing jointly, et cetera, and the level of income that you have.

This isn’t a webinar about tax brackets, but it’s part of what we need to understand. I want to give you just a simple example so that we can see how the progressive tax is applied. Let’s say we have a single person who has $100,000 of taxable income. We want to know what tax bracket they are in, how much tax they owe and what is the average or what we call the effective tax rate. If we take a look at the single tax bracket, for the single filer, this is what it would look like. It still goes from 10 to 37%, but you’re going to find, if you look in that taxable income column, that the $100,000 of taxable pay that they have falls into that 24% bracket.

We’re simply not showing you anything after that but know that the rates do exist. If we know we have $100,000 of taxable income, we’re at the 24% tax rate, but does mean that you pay $24,000 in taxes? What it means is that if we look earlier in the table where we have the 10% rate, for the first $10,275 of your income, it is taxed at 10%. Beyond $10,276, up to $41,775, it’s taxed at 12% and so on. So, we’re cheating here a little bit in the taxes owed column, where we’re showing you that the $15,213 as the original amount that’s owed is based on all of the income that was calculated in the 10%, 12% and 22% bracket. We’ve already done the math for you there.

Then what we’re going to find out in the 24% bracket is the amount over the $89,075. We owe 24% of that on top of what we’ve previously calculated. When we’re answering those questions, the first is, what tax bracket are they in? They are in the 24% tax bracket. Just remember they don’t pay 24% of all of their income, just the last dollar. The last dollar is taxed differently than the first dollar in our progressive tax system. So how much do they owe? Well, they owe a total of $17,835 and some change. Remember that is the $15,213 from rates 10% through 22%, plus 24% of anything above the $89,075 in that bracket.

When we’re thinking about their effective tax rate, it’s actually 17.8%. We get that by taking the $17,835 that they owe and divide that by their taxable income, which is $100,000, to get to the 17.8%. Now it doesn’t mean this person made $100,000. They probably made more than that, but we determine that their taxable earnings is the $100,000, just to make our example nice and easy. If you’re thinking, okay, if I have $100,000 of taxable income when I retire, wouldn’t I be in a lower tax bracket when I don’t get that pay anymore and now, I’m getting my CSRS first pension?

The answer is, maybe, but probably not. And here’s why. I want to give you an example of the general concept of why retirees are rarely in a lower tax bracket. Again, let’s say you have a final taxable pay of $100,000. That person that we were just referring to, and that’s right before you retire. You start to now receive your pension, let’s say it’s $30,000. Well, you’re missing $70,000 of lifestyle that you have to pull from somewhere or else your lifestyle goes down. If your goal is to maintain the lifestyle that you have right now as an employee, when you’re retired, we have to figure out where that $70,000 is coming from to make up the difference.

If it turns out that the $70,000 that you pull in from some other source is all taxable, you are right back in the same tax bracket that you were right before you retired. Let’s take a look at the colored bar graphs over on the right-hand side. While working you have this pay, it’s all purple. $100,000 right before you retire. That’s the taxable portion. When you retire, of course, you don’t see any pay there anymore. That’s regular, employee pay. You see in the blue area you have a pension, you have Social Security, right? That’s assuming of course you’re 62 when you retire, and you go ahead and take it.

But those two things are going to be taxable and you’re going to see more of that today. But then you think, well, I’ll just take money from the TSP. Yeah. Well, the traditional TSP is taxable, too. You’ve just now, on top of your $30,000 a year pension, added two other sources that are taxable. And so, we have to get smart on what this is really going to mean for us in the grand scheme of things, with the way that we are taxed. How can you actually be in a lower tax bracket? Well, I’d like to share with folks that there are only two reasons that you end up in a lower tax bracket in retirement. One’s not very good and one’s amazing.

The first is, you have less money and so you pay less tax, right? I don’t know anybody who wants to have less money available to them in retirement, and thereby end up in a lower bracket. That loses the whole purpose of the game here. The other reason, and the one that I love, is that you can end up in a lower tax bracket if you take steps now to give yourself access to money that is not taxed when you receive it later. But know that this takes a concerted effort to build a strategy. This is not an overnight success. This is not the result of a snap of a finger or a single decision that changes all of this. This is a real concerted effort to build a tax strategy to make this work.

I want to share something that tends to be a little bit controversial, but I think you’ll appreciate when I say it. Your CPA might be the wrong person to ask for a tax strategy. The person in your life that you think knows the most about taxes is probably the person who files your taxes. And if you file your taxes yourself, you’re definitely the wrong person to ask for this strategy. You need an outsider looking at all of this with nice fresh eyes. But the reason that your CPA might be the wrong person to ask, is because of how we judge CPAs. And specifically, I’m talking about tax preparers that may or may not be CPAs.

But if the person you go to for filing your taxes, if that’s who you address this question about building a tax strategy, we have to look at how we judge the effectiveness of that person. We do it every year. It’s wrong that we do it, but we do it, nonetheless. That is, we judge this person based on the size of the check that they make us write to the IRS every year. Today, this person is not looking down the road to see what strategy is available. They’re just trying to keep their clients happy right now and not be angry at that CPA when they tell them to stroke a big check to the IRS. Oftentimes even with my own CPA, when I first started working with her, she was great in trying to get me to have a “now” tax strategy, but not the “later” tax strategy.

I had to say, listen, hold on, stop trying to save your job right now. You’re doing our taxes, right? On the personal, and on the business side. You’ve got that. We’re not leaving because we have to write a big check. I need to know what the actual strategy is later. It turns out she just wasn’t equipped to be that person without that permission. So, of course, they all have to work together. Financial planners, CPAs, that’s all part of the big puzzle here. But it’s important that we realize that this person is more worried about you continuing to go to them to file your taxes than they are about what the strategy looks like later.

Having said all of that, let’s jump into our very first benefits topic, which is your pension. Most of you on this webinar are not receiving your pension yet, you’re still working, but I want you to have a good sense of how this works. Right now, as an employee, you make contributions to either the Civil Service Retirement System or the Federal Employees’ Retirement System. Some of you might be in the Foreign Service Pension System. There are little offshoots of this, but for the most part CSRS are first.

You need to know that this an involuntary contribution. This is not you choosing to put money in the TSP or some other place. This is involuntary. It’s simply a percentage of your pay that you are required to make into your retirement system every pay period. I’ve listed out the different percentages based on the different type of employees there are, both under CSRS and FERS. These percentages vary widely, and I’m not going to get into the politics of why some have to pay more than others, but we need to recognize that there are different percentages that have to be paid into the retirement system.

In the event that we have any of our Special Provision Employees: law enforcement officers, firefighters, and air traffic controllers, they’re going to pay an extra half a percent from percentage that you see in that middle section. If you’re one of those, just know your percentage is going to be higher. Now you can’t do anything about these percentages. They’re set, and it is an involuntary contribution. But the contributions that you made to the retirement system while you were working, this is in retirement and looking backwards, that was all made with after tax money. Meaning you paid the tax on that money and did not get a tax advantage in the year in which you contributed the money.

You don’t get to deduct what you pay and defer it from your taxes. It is considered income to you that you put into your retirement system. And since you already paid the tax on the money when it went in, you do not pay tax on that money when it comes out in the form of your pension, which is amazing. But Chris, you told us on the previous slide that our pension was taxable, which is it? Well, it’s a little combination of both. In addition to what you contribute to either CSRS or FERS, there are two other parts of money that make up your pension. Different buckets of money.

The contributions that your agency made to either CSRS or FERS on your behalf is in one of those other buckets, and the growth on all of that money, both what you and your agency contributed is in another bucket. All of this money is taxable when it comes out in the form of your pension. When the dollars that you have personally paid into CSRS or FERS come back to you, that money is not taxed. But all the money that your agency contributed and the way that money has grown over the decades that you’ve worked for the federal government, all of that is taxable.

On the federal level, consider the vast majority of the CSRS and FERS pension that is taxable as ordinary income. This is not earned income, so you don’t pay Social Security and Medicare and all that on those earnings like you do now, this in the form of your pension is ordinary income. There is that small little piece that’s not taxable representing the money that you contributed coming back to you while you’re working. But for our purposes, I would suggest considering the entire pension taxable, so that you are not left holding the bag, not paying enough tax throughout the year, and now you have a big tax bill.

That tax free portion is going to be calculated by OPM. You’ll receive a 1099 to that effect, in January, so that you’re able to file your taxes for the previous year. Now on to state taxes. The CSRS and FERS pensions are typically treated as ordinary income at the state level as well but know that there are some retiree friendly states. Some states don’t tax income on any of their residents. And so of course they’re not going to tax this either. Then there are other states that maybe have a normal income tax, but they specifically do not tax the CSRS and FERS pensions. So, this is a special exception.

Let’s review both sets of states. The first group that we’re going to talk about are the states that have no income tax. Therefore, of course they don’t tax the CSRS and FERS pension. These are the nine states. The ones we hear an awful lot about are Florida and Texas, and they’re very proud that they have no income tax. But we all can appreciate that states still need revenue to function. They still have roads, bridges, and schools and all that good stuff to take care of. In states that have no income tax, they typically have higher property tax and sales tax. So, something to consider when you’re thinking about where you might live in retirement.

This next set of states are states that normally have income tax, but they have specifically chosen to exclude the CSRS and FERS pensions from being taxed at the state level. These nine states are likely pretty good because for the most part, I can think of two exceptions at least, but for the most part, they have more moderate sales tax and property tax. Hawaii being one of them. And the view is really great. I live in Illinois, so I can tell you that property tax is not beautiful here. Let me be clear. Now, the footnote at the bottom indicates that there are five other states that exempt certain federal pensions up to a certain level from being taxed, but it’s not at all or nothing with those five states.

When you’re thinking about where you plan to live in retirement, I really encourage you to think about all of the factors before relocating to a particular state. Don’t just say, well, Florida has no income tax and so I’m just going to move there. It’s one of many, many factors. Keep all of that in mind. Also keep in mind at the state level that you’ll be taxed in the state in which you reside when you receive the money in retirement. This has no bearing on the state you lived in when you retired. Again, let’s say you live in Florida right now, but you decide to move to another state that has no special exception for Feds. You can’t say, well, I retired out of Florida, doesn’t that rule apply? The answer is no, it is determined by you live when you actually receive the money each year.

Living overseas is a whole other ball of wax that has its own tax complications. I’m not going to get into the details of living overseas in this particular session, but certainly consider that before you move. We talked about the pension, which is what you are going to receive when you retire. But what about the Survivor Benefit Plan? This program, just to give a brief overview, allows roughly half of the pension to be protected for your spouse when you die. And it’s going to cost you about 10% of your pension while you’re living to have this protection in place.

Let’s look at the taxability on both the premium you pay and the benefit your spouse receives. As far as the taxes on the premium you pay, you will not pay tax on what you pay to have this benefit. It’s simply not reported as income to you when you retire. We’ll show you an example here in just a moment. Now, as far as the taxes on the benefits your spouse receives, they will be taxed on all the benefits that they get from the Survivor Benefit Program once you die. The spouse is not going to receive tax free income when you die, as far as the Survivor Benefit Plan goes.

Let’s take a look at an example. Let’s say that you’re a FERS retiree, and you have a pension that provides $2,000 per month, just to make are math nice and easy here. As far as the premium you pay, the dollar amount you have to give up of your pension to have this protection, we know that you are protecting $1,000 a month for your spouse, because again, up to half of your pension can be protected. The cost to you is 10% of the pension that you have, which in this case is $200 per month. You as the retiree would only be taxed on $1,800 of your income for that month, not the full $2,000.

There’s a little bit of a tax perk here through the Survivor Benefit Program, but that’s all gobbled up when we look at what your spouse has to do on the back end of this. When your spouse receives the $1,000 a month when you die, it’s all fully taxable to them. And the kicker here is that while you’re alive and both of you are still married and filing that way, you have a different taxable income bracket than a person who’s single. And so, your spouse is not only getting hit with the fact that you’re gone, but they’re also hit with the fact that their tax table just changed, because now they have to file as single.

Not going to get into all the specifics of that, but there’s a lot that goes into this that your spouse is going to need to think about. The next section we’re going to talk is the FERS Special Retirement Supplement. Now, this is a program that allows for most FERS employees who retire under the age of 62 to receive a benefit that is, “similar.” I hate this word, but that’s what the Feds use. That it’s similar to Social Security from the time that they retire, all the way until they reach age 62. I hate the word “similar” because everybody thinks that it means the same as Social Security when in fact it’s normally somewhere between 50% and 75% of your Social Security benefit. It all depends on how many years of FERS service that you had.

I won’t get into the specifics of the Special Retirement Supplement. We have another webinar for that. But I want to just clear the air that this is not the exact Social Security benefit that you’re going to receive. This benefit that you receive as a retiree is taxed as ordinary income. It’s treated just like the CSRS and FERS pension at both the federal and the state levels. It’s all wrapped into one. But here’s the deal, you are not going to receive this benefit while OPM is processing your retirement claim. You’ll eventually get those retroactive payments, but first you need to prepared not to have the income when you might really need it.

But second, where we find tax issues often arise is when OPM has delayed these payments to you. Let’s say it takes them nine months to process your retirement claim and they finally pay it out. But they do so, and of those payments come to you in the new tax year that might put you in the next tax bracket. So, imagine doubling up on the Special Retirement Supplement benefit that you’re receiving in a given year, one that was retroactive, and two that you’re actually earning in that year that you’re receiving as a retiree. You might find, depending on where you fall in the bracket, that you’ve pushed up into a new bracket, which means you simply have to pay more tax than is necessary had it been paid to you properly.

So, getting ahead of this, again, this takes some sincere tax planning to anticipate these things happening, but we want to make sure that you’re aware that this can be a big tax snafu for you in retirement. With respect to Social Security benefits, the vast majority of Social Security benefits are taxable to you. So up to 85% of any amount that you receive from Social Security is taxable. Taxes are not automatically withheld, but you can ask for them to do so. I won’t get into the specifics of that, but it is important to ensure that you’re staying ahead on the tax game and not waiting until you owe the money to try to find it. That will not serve you well, whether it’s talking about Social Security or anything else that we’re talking about today. So, get ahead of that.

At the state level, the states get to decide if they’re going to tax Social Security benefit at the state level. Ironically, the Social Security Administration does not have the authority to withhold state income tax from your Social Security benefit. Isn’t that strange? If you happen to be in a state that requires you to pay tax on your Social Security benefits, you have to make those payment directly to your state. Let’s take a look at the 13 states that do tax some portion of your Social Security benefits. Not necessarily all of it. Every state’s going to be a little bit different, but these are the 13.

Again, not a reason to move into or out of a state, but something to consider when you’re thinking about where you will live in retirement. Next up is the Federal Employees Health Benefits Program. Taxes vary on FEHB premiums because of when you’re paying them. While working, you pay FEHB premiums with pre-tax dollars. Dollars that you have not claimed as taxable income yet and paid the tax on. But in retirement you pay FEHB premiums with after tax dollars. What does this all mean? Let’s take a look at an example. Far right-hand side, here you are in a 24% tax bracket, and we’re going to show you in the Blue Cross Blue Shield, high self plus one plan.

The premium is about $7,500 a year. That’s the pre-tax cost. What that means is while you are working to pay $7,529 to Blue Cross, you only have to have $7,529, because you don’t have to pay any tax on it, which is great. But once you’ve retired, you have to pay with after tax money, which means that you have to have roughly $9,900 to pay tax on to end up with $7,529 to pay to Blue Cross. The difference between these two numbers is your new tax burden as a retiree. About $2,300 of tax that you owe as a retiree, that you never had to think about as an employee. When people ask, why am I not be in a lower tax bracket in retirement? It’s because of things like this that you don’t even know are creeping around the corner that are going to come up to bite you.

Now, let me be clear, as a retiree, the premium that you actually pay is the exact same as what an employee would pay for that same plan. But it feels more expensive because have to be ready to pay the tax on that money to have enough left over to pay the bill to FEHB. In this case, that bill is to the tune of $2,377. And we’d love not to pay that, but that’s just the way the cookie crumbles in retirement and we have to be prepared, but that is a very real tax burden that we have to stomach.

The next thing that’s associated with FEHB is the Flexible Spending Account. The FSAs are a really great way to set aside some pre-tax money while you’re working, and it can only be used exclusively for qualified medical expenses. Band-Aids, prescriptions, there’s a whole big, long list of things that you’re able to buy with this money. But you need to understand that FSAs are only available to you while you are working. They are not available to you as a retiree. And when you retire, any money that is left in your FSA is forfeited.

You’re going to have about 10,000 Band-Aids in your medicine cabinet if you’re not careful. So, use that money wisely. You do not want to leave that money on the table and have it forfeited to the government. Use up everything you have in the FSA. Let’s talk about the Federal Employees’ Group Life Insurance. This program allows you to elect up to about six times your salary to be paid out when you die. I won’t get into the details of the breakdown of each of these, but roughly you’re talking about six times your salary.

The taxes on the premium that you pay, you will pay tax on all the money that you’re paying into FEGLI while you’re working and in retirement. While you are alive, this is after tax money that you are using to pay your FEGLI premium. But what happens when you die, and your spouse receives the money? Well, your beneficiary, whether it’s your spouse or anybody else will not be taxed on any of the benefit that they receive from this program. All FEGLI proceeds, and frankly any other life insurance proceeds in the private sector, all go to your beneficiaries, income tax free.

A great perk, you still have to pay tax on what you’re using to pay the bill every month while you’re living, but when you die, your beneficiaries are not going to be taxed on anything that you leave them under this program. Next up is the Federal Long Term Care Insurance Program. This program allows you to elect coverage to be paid out if you need long term care services. If you’re not able to feed yourself, bathe yourself, dress yourself, and you need some help, you can pay a company to be able to help you. That’s the whole purpose of long-term care insurance. Let’s break down, just as we did for FEHB and FEGLI, the taxes on the premium you pay, you will pay tax on that. You do not get a tax deduction on that premium.

When you go to receive the money later, you are now on claim. The long-term care insurance company is now paying out a bill to you, either directly as a reimbursement or perhaps direct to the carrier, you don’t pay tax on any of the benefit that you receive when you actually need care. Again, a great perk. You just have to know when the tax is levied and when it’s not. We’re making pretty good time here. I know I’m moving pretty rapidly, but I want to be able to get to all these topics while we have the attention of the vast majority of you before you have to hop off.

This next section on the Thrift Savings Plan is not quite as simple as the others that we’ve reviewed. So, there’s going to be quite a number of items that we’re going to talk about within the TSP, with respect to taxes. Some tax points that I think are very worthy of covering today. The first are taxes on contributions, distributions, and loans. The idea of tax diversification. Required Minimum Distributions that are going to be required later and taxes for your beneficiaries. First, let’s talk about taxes on the TSP when the money goes in and when it comes out.

As far as when the money’s going in, how your taxed today depends on which tax bucket you choose. For all the new money you’re contributing to the TSP this year … Is it traditional TSP? Is it Roth TSP, or is it some sort of combination of both? We’re going to show an example here in just a second. Now, as far as when the money goes out of TSP, how you’re taxed later depends on which tax bucket you choose to pull from in retirement. Is it from the traditional TSP? Is it from the Roth TSP or a combination of both? There’s some flexibility here, but it requires your action. It requires you to do something to get it.

I’d like to walk through both the traditional and the TSP that work very, very differently than each other. We want to make sure that we’re very clear on how these work. We’ll start with the traditional TSP. Starting on the left-hand side of the screen, we need to talk about when the money goes in and then on the right when the money comes out. When the money goes into the TSP, if it’s traditional that you’re choosing, you save tax “today” on the principle. That is the money that you are putting into the traditional TSP. It’s not taxed when it goes in. We know that because you deduct it from your taxes when you file for that year. Let’s say that’s $100,000 of principle that you’ve put into that account, that blue portion of what you see on the screen.

We know that that $100,000 over, of course, a long period of time has not been taxed. When that $100,000, that principle, comes out to you in retirement, it is fully taxable. You haven’t paid tax on it yet. And so, you bet when it comes out later, it’s all going to be taxed. But what a lot of people don’t realize is in the traditional TSP, all of the growth that has happened in the account is also fully taxable. You pay tax later on the principle and the growth. If you put $100,000 in and you’ve doubled your money, so now we have $200,000 in the traditional TSP. If you take all of that money out, whether at one time or over a long period of time, that $200,000 is all going to be taxable to you.

This is the proverbial kicking the can down the road and hoping taxes look better later, when most of the time they don’t. Let’s talk about the Roth side. Same scenario, when the money goes in, you go ahead and pay the tax today on the principle. So, you do not get a tax deduction. Or what we really call a tax deferral, where we’re kicking the can down the road here. You’re going to go ahead and pay the tax on the principle, so that $100,000 that you put in the TSP, again, over many years, you have already paid the tax on. When that principle gets paid out to you in retirement, it is all tax free.

Again, just like on the traditional side, what most people don’t realize and where the beauty of the Roth component of the TSP really lies, is that all of the growth on that money is also tax free. In both scenarios, you are not going to get away with not paying tax on the principle, either now or later, you’re going to have to do it. But in the Roth, this special little feature of the way the Roth account grows, is that as it grows over a long period of time and likely far exceeds the principle that you’ve actually used to fund the account, all of that growth is tax free.

When I said earlier that you have more control than you think, about what taxes are going to look like later, in this case, you would be creating a bucket of money that you can tap into tax free in retirement. You can keep yourself in the bracket that’s most appropriate for you instead of perhaps exceeding that with taxable and income. Hopefully, that is helpful to you. These are two of our favorite slides to review in our retirement workshop. And so, it’s always an eye-opening thing when people really realize how the Roth account works and all the amazing little features associated with that part of the program.

Now we need to talk about a topic that I think a lot of people struggle with, and that is loans. We don’t love TSP loans. We think they’re terribly counterproductive. This is a retirement asset. And so, using the money now in the form of a loan really does not set you up for success. But aside for of that, if you’ve already taken a TSP loan, once you are either retired or separated from federal service, you have 90 days to repay it, or it’s declared taxable. The same goes true if you default on the loan, even while you’re still working, if you fail to pay it for whatever reason, you go into a non-pay status or whatever, it’s going to be declared taxable to you at that point too. And so that’s no fun.

But here’s the deal and why we really discourage TSP loans, because we need you to be prepared to be taxed twice on this money. But people say to me all the time, but Chris, are you sure? That doesn’t sound right. Nobody’s ever told me that I pay tax twice on my TSP loan. That doesn’t make any sense. They didn’t tax me when they gave me the money. No, you’re right. Let me show you how this works. We’ve got a lot going on in this slide. Let me orient you to what we’re looking at. The blue section at the top, let’s say is your traditional TSP balance. Along the way, if we go to the bottom, you’ve got your contributions that are going into the account to fund the balance.

And then later you’re like, gosh, I need $30,000 out of my TSP. I’m going to take a loan. So, you take $30,000 out and it’s not taxed at that time. But now you have to repay the loan. Well, do you get to pay it with pre-tax money or after-tax money? It’s after-tax money. That’s the first moment in time that you’re going to pay the tax on that $30,000. The tax goes, you have to pay the tax, separately, and then the $30,000 eventually all gets repaid. And so, you have “replenished your account,” right? But later in retirement, you go to take out that same $30,000, and you will eventually, you’re going to be taxed on that $30,000 again, in the form of a distribution.

Please do yourself a favor, avoid taking TSP loans, because I’ll tell you, if you don’t love paying taxes once, you’re going to hate paying it twice on the TSP. The problem with this, and why so many people question this, is that it’s not obvious when you are paying the tax. Because it’s hidden in the repayment, because it’s not pre-tax money that you’re using to repay it. It’s after-tax money. And so, it’s not readily obvious to you what is happening and when it is being taxed. So please be very careful. I’m not here to shame you for taking a TSP loan, I know things happen and sometimes it’s the only choice that you have, but you need to understand there are legitimate tax consequences to taking a loan.

Let’s talk about one of my favorite topics, which is tax diversification. The concept here is that in retirement, you want to have different buckets of money that are available to you to choose from, that are all taxed differently. So that you get to choose when and how to take money from each one of the buckets. And it’s going to largely be determined on the tax environment that you are in. When taxes are low, you maybe don’t mind taking money from the taxable account. That would be the traditional side of your TSP.

But when taxes are really high, you probably prefer to take that money from a tax-free account, at least part of it, because you’re not going to have to pay the bill. You’re not going to have to pay the tax on that money when it’s coming from a Roth source. This idea of tax diversification on paper looks simple. It is not simple. This is part of that strategy that I talked about, that does require your intent effort and a lot of brain power to make this work. And so, from a tax diversification standpoint, this is similar to the diversification that you might make in your actual investments, whether you spread your money between the G, F, C, S, and I, if you have different mutual funds out there, whatever that might look like for you, that’s investment diversification.

But here we’re talking about diversifying the way we are taxed on that money. And so, if we want to be able to pull money from the Roth TSP, we first have to fund the Roth TSP. We have to get money in there to be able to be able to pull from it later. The next topic within TSP that we’re going to talk about is Required Minimum Distributions, or RMDs that we so lovingly call them. I’m not going to go into all the rules, I have them here for you. But essentially the IRS says, hey, by the time you’re 72, we’re going to be tapping our watch. We’d like you to go ahead and start tapping into all that tax deferred money that’s sitting in your retirement accounts.

Things like traditional IRAs, Thrift Savings Plan, any of those accounts that were tax deferred, meaning you’ve got a tax advantage in the year in which you contributed to them, but know you have to pay them later. The IRS wants their money. They’re going to determine a percentage. There’s actually a table that’s not updated all that often, so it’s pretty standard. But the percentage that they dictate that you have to take out of your account increases each year. So, as you start to get older, more and more and more of your account has to come out. Starting at age 72, you have to take 3.65% of your account balance as your required minimum distribution.

This number is at odds with the strategy that most financial professionals recommend. Years ago, you may have heard of the 4% rule. It’s still floating out there, but it’s the idea that if you have an investment asset like this, that you could draw 4% of that asset each year with a pretty good likelihood that you’re not going to run out of money. Now, the reason I say that was years ago, is that most advisors do not want to see that high of a percentage coming out of their retirement accounts. There’s still danger there in taking too much out. Many of them are closer to the 2% level now. So, the 2% rule instead of the 4% rule, so already at 72, you’re taking out 3.65% of your account, and it only gets worse from there.

If you actually need this money, that’s one thing. You were going to take it anyway, and so the fact that the IRS is making you do it, is perhaps no big deal. But if you weren’t planning to take this money, if you were trying to preserve it, for instance, you don’t have a choice at 72 and beyond. The IRS requires you to take this, whether you need it or not. But something odd happens in the TSP, that I want you to be very aware of. As you’re thinking about that tax diversification that I talked about, and you’re thinking, we’ll do the Roth side. That’s cool. Well, this odd thing that happens in the TSP has to do with the Roth account. The Roth side of the account.

In the private sector, RMDs are applied to traditional IRAs, but they are not applied to Roth IRAs. Meaning if you have a Roth IRA, again, a private sector account, the money will just keep growing and growing and growing. If you don’t need it, you don’t touch it. The IRS can’t make you take money out of that account because frankly it does them no good. It is not taxable anyway. You’re not going to stroke a check over to the government, but that account can grow for a really long time. Of course, it can be given to your beneficiaries and all of that tax free as well. So, lots of perks over there on the private side.

But in the TSP, something very, very bizarre happens. RMDs are applied to the traditional TSP, which we would expect, and they are applied to the Roth TSP. This means that you will deplete your assets in the Roth account faster, which limits the ability for it to grow tax free, specifically for a long period of time. They had to go to great lengths to make this rule, because this is not how Roth IRAs operate in the private sector. This is incredibly frustrating for so many people who otherwise might want to keep their money in the TSP, but they say, well, gosh, if you’re going to make me take this even when I don’t need it, and it stunts the growth of my tax-free bucket, I’m just going to move it out to the private sector.

And you can. You can take your Roth TSP, move it to a Roth IRA, and then no RMDs are due. There is resolution to this, but you have to be proactive. It doesn’t happen automatically. Now, so we’re done with RMDs. I’ve oversimplified something that’s actually quite complicated here, but I wanted to give you a general overview of how this works. Now let’s talk about something that we get so many questions on with respect to the TSP. And that is, what happens to the TSP account after you die? I’m going to start with you naming someone other than your spouse as the beneficiary.

If you are married, I don’t suggest this because there will be a divorce looming in your future very quickly. But let’s assume you’re not married, and you name a brother, sister, parents, children, whoever that might be. You want someone to get your money. First, they are not allowed to keep their money in the TSP. Once you die, they have to get it out of TSP. When they’re making that decision, they can do one of two things or a combination of these two. They can choose to take all the money in cash, and they pay all the tax now, a boatload of taxes, or they can transfer that money to what we call an inherited IRA. It’s a specially titled account that tells the IRS that there’s some special tax treatment on it.

This inherited IRA allows that beneficiary to take the money out over the next 10 years. And they get to pay tax along the way, instead of all at one time. This is a pretty great opportunity, right? To be able to give the money to whomever your beneficiary is, and they have some flexibility in how they’re taking the money out. Instead of it looking like they made half a million dollars in one year and have to pay taxes if they made that much. Now they’re able to spread it out over a longer period of time and have a little bit smaller of a tax burden, an incredibly smaller tax burden over those 10 years.

This is all great if you’re not married when you die. But most of the time we have Feds who are married. And so, a very common beneficiary is a spouse. Let’s talk about what happens to the spouse and these subsequent beneficiaries. Here’s our example. Now, there’s about a 50, 50 split of men and women in civil service. I’m simply going to, for this example call the husband the federal employee, so we can keep the he’s and she’s a little bit simple for us. The husband’s the Fed, the wife is the beneficiary of the TSP. He dies. The account is transferred to a beneficiary TSP account in the wife’s name.

It’s still in TSP. It is now in her name. She’s not allowed to contribute any more to it or anything like that, but she can move around the funds and all that. But it’s going to default to the Lifecycle Fund that is most aligned with her age, which is a weird thing that they do. They change up how all of your investments were set when the money goes to your spouse. That’s for another topic that I suppose we’ll talk about another time. Here’s the deal. Your spouse now has this beneficiary TSP account, and she decides that it’s smart to go ahead and name new beneficiaries. And we agree. You should always have beneficiaries on these accounts. And so, she names the kids as the beneficiaries, and then she dies.

In this scenario, the kids have to take all of the money in lump sum. All at one time, they have to take in cash and pay taxes now. Let’s say you’ve got, we’ll keep it simple, $300,000 in the TSP, and you’ve got three kids. Each of them, assuming that you have it set this way, each of them get $100,000. It’s as if they made $100,000 in that year, on top of what they actually made, and they have to pay tax on all of that. As opposed to that money coming out to an inherited IRA, which allows those kids to spread out how they’re using the money and how they’re taxed on the money over the next 10 years.

It is for this reason that we strongly encourage widows to take money out of the beneficiary TSP account, put it into a spousal inherited IRA, which again has special rules. And then from the spousal inherited IRA, it can be passed to the children in their own inherited IRA. Again, there’s a lot going on in this example here, but simply doing what the default is, that the government has in mind for you does not always set you up to a great end. And so, I share that with you, with the greatest heart I can possibly muster here, that you and your spouse understanding how this works will likely change the decision that is made on where this money stays.

Leaving it in the beneficiary TSP account, while it seems simple and while the TSP might have served you very well while you were alive, it will not serve the next beneficiaries well when your spouse dies. The way to solve that is that the spouse when they receive this money, it moves to a spousal inherited IRA. They name the children as the new beneficiaries. So, when the spouse dies, the children are now able to take it to an inherited IRA, a non- spouse inherited IRA, and then they’re able to have all of the tax advantages associated with those types of accounts.

There’s so much to think about with all these taxes! I know that I moved very rapidly through all of this, but I want to take a minute to do some wrap up and some next steps. Taxes are super complicated. Let me just be clear. I deal with numbers and federal benefits all day long, but taxes are tough. But we have more choice than we think. It just requires our effort. And to have a clear guidance on what to do. If we really want to control our tax situation in retirement, we can, we just have to have a tax strategy. And without that tax strategy, you are likely to pay way more taxes than are absolutely necessary. And good lord, who wants to do that?

Remember, I said this at the very beginning, I’m going to say it again, taxes are a very real part of retirement and should be a very real part of your financial planning. Now, a lot of people ask, well, can you go ahead and set me up with somebody that can make all this happen? Sure. We could, but without context, a lot of this won’t matter. And so, our first step to getting you on your way to great retirement is to have you come to one of our workshops. This is where we talk about, in more detail, all of the benefits that you have, and the tax is kind of a byproduct of each of those benefits.

We need your brain to be super clear on the benefits themselves, so that when you have the conversation about the tax later, your brain will be in the right spot. So, attend a workshop. These are in-person training sessions. We are not currently doing any virtual sessions. There is no cost to attendees. These are typically held out in the general community, at a library, a university, a hotel, lots of different venues that we utilize. And we cover all of the federal benefits topics, and those decisions to be made. This will help you to bring everything together. I touch the treetops of each of these benefits of generally how they work, but to see those details, you’ve to get to one of our workshops.

You can see all the details and the different locations and dates available by going to fedimpact.com/attend. Now, for handouts and replay, like we always do, the handouts are available here in the webinar portal. You’re able to download them here. If you’re on your phone or a tablet or some other place that it’s difficult for you to download a PDF, it will be emailed to you, no problem. Same thing with the replay, everybody who was on here today, as well as anyone who was registered will get a link. Of course, this goes out into our normal newsletter as well. So, if you weren’t originally registered, you’re able to opt in to be able to get the replay.

Our next webinar was actually inspired by last month’s webinar on the Survivor Benefit Plan, because we were talking about the Survivor Benefit Plan when you’ve retired from federal service, but all these questions in the Q&A were like, but what if I die while I’m still working? We were shocked at how many people actually thought they weren’t even going to make it till retirement! And they wanted to know what happens to all of my benefits if that happens. So, this is probably the most morbid topic that we’ve at least headlined that we’ve given. What if you die while you’re still employed? So, we’re going to cover that on April 14th, one o’clock central, here in our FedImpact webinar.

You can register for that session at fedimpact.com/webinar. It is ready right now for you to enroll and we will make sure that we’ll cover all those topics of what happens when the unexpected happens. For all of you who think you might not make it all the way until retirement, or you might have a spouse who’s curious what happens in that situation, please join us on next month’s webinar. We are all done for today. Thank you so much for joining us. Again, I know that I went very rapidly through all of these topics, but there was so much that I wanted to cover with you that I didn’t feel right taking any of this material out.

If you need to take another pass through this or re-listen to a section that you are a little fuzzy on, you can certainly do that. We would welcome you to re-listen to that replay and get everything out of this topic that you possibly can. And remember to find a workshop close to you, go to fedimpact.com/attend and to register or for next month’s webinar on, what happens if you die while you’re still employed? Go to fedimpact.com/webinar. Thank you. Have a wonderful day and we’ll see you next month.

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