Avoiding Tax Pitfalls

Will Rogers once said, “The difference between death and taxes is death doesn’t get worse every time Congress meets.” Many people today would probably still agree with this sentiment.

The obligation to pay taxes doesn’t end when your federal career ends. Federal retirees generally have to pay federal and sometimes state tax on their retirement income, including their Civil Service Retirement System or Federal Employees Retirement System benefit, income generated from their Thrift Savings Plan accounts and Social Security benefits.

Congress approved a major tax overhaul last December. It remains to be seen exactly what impact it will have, since the specifics of the implementation of the law are still being worked out. The IRS has been providing updates as information becomes available.

Federal retirees can use the following resources to find information about taxes on their TSP withdrawals, federal retirement benefits and Social Security benefits:

• IRS Publication 721: Tax Guide to U.S. Civil Service Retirement Benefits
• IRS information for Seniors and Retirees
• Important Tax Information About Payments From Your TSP Account from the TSP
• Annual State Tax Roundup from the National Active and Retired Federal Employees Association
• Income Taxes and Your Social Security Benefit, from the Social Security Administration

In 2012, I wrote a column called “Reductions and Withholdings” to help federal employees understand that there are not only tax and insurance withholdings from a CSRS or FERS retirement benefit, but also certain reductions to the full retirement benefit that will have a negative impact on your benefit income. If you are preparing for retirement, you may want to review this column to get a more accurate idea of your net retirement income from CSRS or FERS. You may also want to review a column published earlier this year, “Tax Assessments.”

Because tax issues are such an important part of retirement planning, I wanted to share a recent email that I received from a reader, Trudy, because it underscores the pitfalls of neglecting the chore of pre-retirement tax planning:

I finally am resolving my tax issues due to underwithholding, but am complaining about some serious misinformation or inadequate information that I received from my office before retiring. I wanted to share with you because I know that I am not alone in how this worked out….

1) Thrift Savings Plan payments: I was advised by human resources and by the TSP on page 8 of the pamphlet providing important tax information about payments from your TSP account to check married with three exemptions (as is standard practice), not understanding the consequences of this, which is that I seriously underwithheld.

2) CSRS or FERS retirement: For some reason which I don’t understand, my FERS annuity was also underwithheld. I don’t know why withholding would have changed from my salary, but it did.

Due to underwithholding, not only did I have a big tax obligation for 2017, but I now have to do catch up withholding for 2018. One thing that caused my ignorance/confusion for my FERS annuity was that I assumed the withholding was low because I was “recapturing” the retirement contributions I’d made with after-tax dollars that I contributed to the retirement fund during my career. That turns out to be only very partially true. Most of the annuity is not recaptured funds.

I also made my own state tax mistake. Maryland doesn’t tax Social Security, and gives $29,000 exemptions for pensions. I assumed they were separate exclusions, but actually they are combined. That’s my own fault, however, as I didn’t read the fine print.

The bottom line, according to Trudy: “It’s turning out to be pretty painful to catch up with my tax obligations in a compressed period of time.”

To avoid a situation like Trudy’s, you may want to engage with a professional to create a “dummy” tax return with your retirement income used instead of your salary. If you do your own taxes, you can run your tax software using your estimated retirement income figures. Don’t forget to include items such as lump sum payments for annual leave, income you may have from a second career, an unpaid TSP loan balance, and your final salary payments that will be paid in the year you retire.

Agency retirement and benefits personnel are not trained in this area and the software that is available to provide retirement estimates does not adequately address proper tax withholding. Do your due diligence to be sure that you don’t have an unwelcome surprise at the time you file your first tax return as a retiree.

Update 6/8/18: Kim Weaver, director of external affairs for the Federal Retirement Thrift Investment Board, which oversees the TSP, sent the following statement on Trudy's message: "Trudy states that we recommend withholding at married with 3 kids. That’s incorrect. 'Married with 3 kids' is under the heading of what will the withholding rate be, as an illustration for the participant.  It is followed by a column that says you can increase your withholding, if you desire. We don’t make a withholding recommendation one way or another–we are simply providing information to allow the participant to make that decision."