Money is just money, right? Well, not exactly when it comes to retirement income. It’s not as straightforward as you would think. There are a number of things different about retirement income compared to your regular paycheck. Many of the changes will benefit federal employees, but not all. For example, taxes are just one of the things that will be different in retirement.
A common way for employees to figure out how much retirement income they will need is to perform a side-by-side comparison to their current take home pay. While this isn’t a bad way of thinking, here are some things you may be missing.
Your health insurance premium is deducted after taxes
While you are a federal employee you qualify for what is called premium conversion. This is simply a fancy way of saying that your health insurance premiums are deducted from your pay before you are taxed.
In retirement you no longer qualify for premium conversion. You will pay taxes on your entire check, and then your FEHB premiums will be deducted.
The exception to this rule is for Law Enforcement Officers (LEO). An LEO retiree can deduct up to $3,000 of FEHB premiums each year.
Another thing to note is that your health premiums are the same in retirement as they were as an employee.
There are a number of deductions that you will no longer have in retirement such as:
- FERS contributions – 0.8% for regular FERS employees
- FICA – This is the Social Security and Medicare deduction which equals 7.65% for federal employees.
- TSP – in retirement you can no longer contribute to the Thrift Savings Plan
- Union dues – union dues will no longer be deducted in retirement
How will your FERS retirement be taxed?
Taxation will be a little bit different in retirement. As a FERS employee, your retirement income will come from three main sources: FERS annuity, Social Security, and Thrift Savings Plan. Each of these three incomes will be taxed a little different.
Taxes on your FERS annuity
Your FERS annuity will be taxed as ordinary income with the exception of your contributions which was only 0.8% per paycheck. Instead of getting all of your contributions back first, they will be spread out over your lifetime.
This means that the majority (approx. 95-99%) of your FERS annuity will be taxed as ordinary income.
Taxes on Social Security
Taxes on Social Security are based on your provisional income which is your Adjusted Gross Income plus half of your Social Security benefits and tax free income.
For example, if you have provisional income of $32,000 for Married Filing Jointly (MFJ) you will pay taxes on 50% of your benefit. If provisional income is above $44,000 then you will pay taxes on 85% on your benefit. Thresholds for single taxpayers are $24,000 and $34,000.
Taxes on retirement distributions
The third source of income for FERS employees comes from the TSP and investment income. TSP contributions are pretax (unless you contribute to Roth TSP), therefore all distributions are taxed as ordinary income. IRAs are taxed the same as your TSP.
Distributions from Roth TSP and Roth IRAs are income tax free.
What about state taxes on retirement income?
One thing that hasn’t been mentioned yet is state income taxes. In Illinois we pay 4.95% income taxes on all earnings, however, the state does not tax retirement income. That means that there are no state income taxes on a retiree’s FERS annuity, Social Security, or TSP distributions.
Taxation by states on retirement income will vary from state to state. Here is an article with info on taxes on retirees.
Summary
If you’re thinking about how you are going to receive income in retirement, be aware that it’s not a straight path from where you are. It’s a different financial world and there are many changes that need to be taken into account.
It is important to know what will change in retirement and how you will be taxed. If you would like help putting your retirement plan together you are welcome to schedule an introductory call.
Brad Bobb, CFP® is the owner of Bobb Financial Inc, and an expert in retirement planning for federal employees.