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Federal employees will face a challenge in retirement – figuring out how to spend their money versus accumulating it. After spending 30+ years saving and investing, distributing funds can be daunting, but it’s exactly what’s needed in retirement. Tax planning during the distribution phase can be a key element.

Warning: this blog post is very detailed and contains a lot of numbers but if you are doing your own retirement planning you need to be able to follow along with the scenario. If you have an advisor helping you with retirement planning this will give you an example of what the advisor could, or possibly should be doing and it would benefit you to understand what is going on. Now let’s get to it!

There are many questions that come up for new retirees when they start to think about retirement distributions. Here are a few of the most common ones I’ve heard.

• What accounts should I take distributions from?

• How much of a distribution can I – or should I – take?

• How will I pay taxes on my distribution?

Let’s look at an example – here’s Joe and Mary Federal’s situation.

This couple would like to have $8000 a month for retirement spending. They plan to leave their assets to their 3 kids and any extra income above $8,000 would likely be spent on kids or grandchildren.

Joe and Mary have done a good job of saving and have the following account totals.

• TSP = $850,000
• Roth TSP/IRA = $220,000
• Joint Account = $250,000
• High Yield Savings = $80,000

Here are their future income sources.

For informational purposes:

The 12% federal income tax bracket for Married Filing Jointly is $22,000 to $89,450. I will use the terms Adjusted Gross Income (AGI), Taxable Income and just Income to the couple which consists of net dollars for them to live on. All three terms are very different.

This type of income scenario is very common for federal employees. As you can see above, Joe and Mary’s income will change when they turn 62 and will change again when they turn 67 due to delaying Social Security. They might also consider having Joe delay Social Security until age 70 to get the highest benefit possible as well as the highest survivor benefit possible, but for now they are going to plan on collecting at age 67.

FERS Distribution Strategy Ages 60-62

During this period, Joe and Mary will pay $5,308 in taxes annually ($442/month), assuming they live in a state that doesn’t tax retirement income or has no state income tax. This reduces their monthly income to $5,858 ($6300 - $442), leaving a monthly shortfall of $2,142 needed to meet their spending goal of $8000/month.

Their taxable income of $47,900 puts them in the 12% tax bracket (not including any taxable interest and dividends to keep the example simple).

Where will they draw the additional funds from to cover their annual shortfall of $25,704 ($2,142 x 12)?

They could use their savings account to cover the two years of shortfall, but taking distributions from TSP may be a better option since they are in the 12% tax bracket which will only last until age 67 or 70 at the latest. They would need a distribution of $29,209 each year to net $1,080 a month after tax. This moves their taxable income up to $77,109.

However, Joe and Mary aren’t done with their planning yet. They decided that doing a conversion of $12,000 would make sense to do both years since their time in the 12% tax bracket is limited. Their rationale is that they will be in the 22% or higher tax bracket in 7-10 years, therefore they should take the maximum distribution that they can while in the 12% tax bracket.

It is a priority for them to stay in the 12% tax bracket in order to pay 0% on long term capital gains (most of their gains on the joint account will fall in this category).

FERS Distribution Strategy Age 62-67

The table below shows income sources for these years plus tax info. Keep in mind their spending needs are a total of $96,000 annually ($8000 a month).

Their taxable income in these years is $21,500 ($49,200 - $27,700 standard deduction). A net of $47,050 after taxes are paid on their FERS Annuities leaves a spending gap of $48,950 ($96,000 - $47,050). It will take a TSP distribution of about $55,600 to net the amount needed.

This takes their taxable income to $77,100 ($21,500 + $55,600) for the year. Again, they could use other accounts to meet their spending gap but they would prefer to maximize their withdrawals from tax-deferred accounts while they are still in the 12% tax bracket.

They are still $12,000 short of the top of the 12% tax bracket, so they plan to convert $12,000 to their Roth IRA every year.

What did they accomplish with their distribution strategy from age 60-67?

• They managed their tax rate to stay in the 12% bracket.
• They reduced the amount of funds they have in their tax-deferred bucket (TSP) therefore reducing the amount of their future Required Minimum Distributions (RMDs).
• They gave their more tax efficient assets (Roth IRA and Joint Account) 7 years to grow while paying no income taxes on them (assuming the joint account is all long-term capital gains).
• Gave themselves more flexibility to engineer their tax rate in the future (by reducing tax-deferred assets and increasing tax-free).
• Decreased the amount of income taxes their beneficiaries will pay on their estate.

Retired FERS Age 67

At age 67 they will both realize their full income that will last for the rest of their lives. Here is what their income and tax situation will look like at that time.

Their income (or take-home pay) before taking any investment distributions is $97,056 which covers all of their spending needs. Their taxable income is $54,870 due to only 62% of their Social Security being taxed.

Joe and Mary plan to continue doing TSP conversions while in the 12% tax bracket and will consider doing larger conversions in the future if necessary. One thing they need to be aware of now is that any additional income will cause more of their Social Security to be taxed. It looks like they could convert around $35,000 and remain in the 12% tax bracket; however, additional taxable income increases the amount of their Social Security that is taxed. Therefore, the amount they can convert and remain in the 12% bracket is only $22,000.

This brings up another topic which is tax on Social Security and effective tax on additional income. Because of this tax, Joe and Mary may want to delay Social Security until the age of 70, giving them 3 more years to do conversions at a lower effective tax rate.

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This is an example of what a distribution plan could look like for married federal retirees. Keep in mind that there are many other things involved in a financial plan that aren’t included here. If you are at or near retirement and you’re confused by all of this, schedule a call with me to see if we would be a good fit to work together.

Again, this is an example, please consult your advisor or accountant for your specific situation. 

Brad Bobb, CFP® is the owner of Bobb Financial Inc, and an expert in retirement planning for federal employees.