Taxes can be one of the most intimidating topics for federal employees approaching retirement. After a long career of hard work, the last thing you want is for the government to take a massive chunk of your hard-earned savings. The big question on every Fed’s mind is: how much will you actually have to pay in taxes during retirement, and what can you do to keep that number as low as possible? Let’s break down how your different income sources are taxed and explore some strategies to protect your wealth.
How Your Federal Pension is Taxed
When it comes to your FERS pension, the reality is that the vast majority of it will be taxable. While you did pay some money into the pension system during your career, for most retirees today, about 95% of their pension counts as taxable income. For example, if your pension is $1,000 a month, $950 of that will be taxable, while only $50 comes to you tax-free. Additionally, your health insurance premiums (FEHB) are no longer paid with pre-tax dollars in retirement, meaning you will be taxed on your gross pension amount before those premiums are deducted. Depending on where you live, your state may also tax your pension.
The Tax Rules for Your TSP
Your Thrift Savings Plan (TSP) is another major income source, and how it is taxed depends entirely on whether your money is in the Traditional or Roth balance. Withdrawals from your Traditional TSP are fully taxable as ordinary income, which is generally the highest tax rate. On the other hand, qualified withdrawals from your Roth TSP are completely tax-free. Keep in mind that you will eventually be forced to take Required Minimum Distributions (RMDs) from your Traditional TSP, usually starting at age 73 or 75. When pulling money from your Traditional TSP, it is crucial to avoid taking massive lump sums because that will spike your taxable income for the year and likely push you into a higher tax bracket.
Social Security and the Progressive Tax System
For most federal retirees, a significant portion of Social Security benefits will also be taxable. If you file a joint tax return and your combined income is above $44,000, which is very common when combining a pension, TSP, and Social Security, up to 85% of your Social Security benefits will be taxable. When calculating your overall tax bill, it is important to understand that the U.S. uses a progressive tax system. This means that moving into a higher tax bracket does not mean all your income is taxed at that higher rate; only the new dollars that fall into that specific bracket are taxed at the higher percentage.
Strategies to Lower Your Tax Bill
Fortunately, there are several proactive strategies you can use to reduce your lifetime tax burden. One powerful tool is a Roth conversion, which involves moving money from your Traditional TSP or IRA into a Roth account. The best time to do this is during years when your income is relatively low, allowing you to pay taxes at a lower rate now so the money can grow and be withdrawn tax-free later. If you are charitably inclined, utilizing Qualified Charitable Distributions (QCDs) is an excellent way to give money directly from your retirement accounts to charity while keeping your taxable income down.
Optimizing Withdrawals and Location
Your withdrawal strategy can also make a massive difference. For example, it often makes sense to pull from your Traditional accounts early in retirement while letting your Roth accounts continue to compound tax-free. This not only maximizes your tax-free growth but also reduces the size of your Traditional balance, which lowers your future RMDs. Finally, where you choose to live in retirement plays a huge role. Moving to a state with no income tax, or one that specifically does not tax federal pensions, can easily save you thousands of dollars every single year. The key is to start planning as early as possible so you have the flexibility to make the best choices for your future.