How Taxes Work for Federal Employees in Retirement: Audio automatically transcribed by Sonix
How Taxes Work for Federal Employees in Retirement: this mp3 audio file was automatically transcribed by Sonix with the best speech-to-text algorithms. This transcript may contain errors.
Speaker1:
Welcome, everybody. Once again, back to the Federal Retirement Show. I am your host, Val Majewski, with American Benefits Exchange. I appreciate you joining us to learn more about your federal benefits and retirement information. Now, I give a lot of federal benefit presentations to various groups, agencies, individuals across the country and try to share with you some of the most common concerns that federal employees are having as far as it relates to current events and keeping things as recent as possible. One of the most sought after, I guess, topics that we've been asked to present about to talk about in our presentations has been taxes. Now, why is that? Well, with everything going on over the past couple of years, a big concern has been what are taxes going to look like for me in the future? The general rule of thumb over the years has been you're going to work your career in retirement, you may make less money, you're probably going to be in a lower tax bracket. So it generally made sense to defer all of your taxes until retirement and therefore you're going to help save money on taxes, get deductions while you're working, and then pay less in retirement. That was the general rule of thumb. Now, maybe not so much. And I ask federal employees, these are not my opinions. These are results of surveys, if you will. What are your where do you think taxes are going to be going in the future? What direction do you think they're heading in? And the consensus, not unanimous, but the consensus, the majority believe that taxes will be higher in the future than they are right now.
Speaker1:
Now, when we help federal employees plan for retirement, the goal is to get you as close to your pre-retirement income in retirement as possible. If that's the case and you're making the same amount of money, well, chances are then you're going to be in a very similar, if not the same tax bracket in retirement. So let's back up. You're planning properly. You're trying to get yourself to the same income level in retirement that you are prior to retirement. Therefore, you're going to be in the same tax bracket as you are today. Now, that's based on today's tax information. And if the thought process is, well, taxes are going to go up, then how do we mitigate our taxes now in order to pay less in the future? And we're going to get there eventually today. But I want to talk to you first about how taxes look currently for you in retirement, because there is a little bit of a misconception out there when it comes to federal employees and information that you're given that your pension, Social Security and TSP benefits are not federally taxed. Now, you may not be in this group. You may understand already that those will be subject to tax. But there's a lot of misinformation out there when it comes to benefits and retirement in general.
Speaker1:
But I've heard this before, that folks would think that pension, Social Security and TSP will not be subject to federal tax. That is not true. Now, they may not be subject to state tax and your state is going to be different, but there are 13 states out there that either do not charge state income tax or do not charge state income tax on pension and Social Security benefits. Perhaps you already live in one of these states. Reach out to us. We can tell you if you're in one of these states or maybe you're planning on moving to one of these states in retirement, which will help limit your tax liability in retirement. But that being said, we're talking about federal taxes today and the misconception pension, Social Security, TSP are not federally taxed. That is not true. They will be subject to some sort of tax. How much? Well, let's dive into each individual segment here so you can see what is subject to tax when it comes to those three items. First, your pension. Now your pension is going to be taxed. Your first annuity, if you're a firs employee, you'll be taxed to the extent of the government's contributions, government's contributions. Now, if you're not aware, the government does put in the bulk of the contributions on your behalf. Check out your leave and earnings statement, your pay stub. You can see exactly on there.
Speaker1:
There's a section. Government benefits paid for or benefits paid for on your behalf by the government. Now to the extent of their contributions. Your contributions are not taxed. Their contributions are taxed. Social Security is subject to an earnings test or an income test when it comes to taxation. And this is a little tricky because people get this confused of what is the tax percentage or what is the percentage of tax that I'm going to pay on my Social Security benefits? This is not that. This is what portion of your Social Security benefits are subject to whatever tax bracket you're in. Now, if you're a single, single filer and you make between 25 and $34,000 in income and income for this purpose is your adjusted gross income, 50% of your Social Security payments. And if that is between 25 and 34,000, up to 50% of your Social Security benefits could be subject to tax. It's not a 50% tax, but up to 50% may be subject to tax. If you make above 34,000, then up to 85% of your Social Security benefits could be subject to tax. Now, that's for single if you're married filing jointly, if you make between 32 and 44,000, up to 50% is subject to tax and above 44,000 up to 85%. It could be subject to tax and this is federal tax. So again, Social Security will be subject to some form of tax depending on where you fall on that income test for federal taxation and what portion is going to be subject to tax.
Speaker1:
Tsp. Now TSP will be taxed as ordinary income, every dollar as ordinary income, unless it's going to be coming from the Roth side, from the Roth bucket. Now, you do have a traditional portion. You may be thinking, well, I put all of my money towards the Roth portion, so I'm good. But remember, all of the agency matching funds go into the traditional bucket. So you will have a portion of your TSP account no matter where you're putting your money that will be subject to tax. But if whatever portion is in the traditional account, that money when it comes out will be subject to tax as ordinary income. So just be aware of that when you're taking distributions from TSP. Now, as a result, when we talk about these different taxes in retirement and limiting taxes in retirement, federal employees have been asking us to say, okay, well, how can I mitigate or try to eliminate as much tax as possible? I do not want Uncle Sam to be my silent partner in retirement. I'd rather not have to pay Uncle Sam any more than I already have. And I certainly don't want his hand in my retirement cookie jar, so to speak. Right. So how do we help mitigate those tax liabilities? Well, first of all, you do have the Roth bucket within TSP. So every dollar that you put into the Roth bucket has already been taxed.
Speaker1:
It will grow based on any interest that you're earning on your investments within TSP, and every dollar that you take out in the future will come out tax free. So every dollar you put in plus the earnings comes out tax free because you've prepaid the taxes. Now, there is additional ways. There are additional ways in which you can put money aside for your future and eliminate tax liability. We've listed two here on this slide. Now, the first one is probably the most common option. It's a Roth IRA. And you may be thinking, okay, I already have a Roth IRA. It's within my TSP. That is a Roth 401. K. You can have an additional Roth IRA outside of that. Now, how does a Roth IRA work, though? Because it's a little restrictive. It's a good plan to put aside money on a tax free basis, but it's a little restrictive. Why is that? Well, they restrict the amount of money you can put in on an annual basis, currently $6,000 per year per person in a combination of Roth IRAs. It's not per account. So if you have multiple Roth IRAs, the combined total can only be 6000 a year if you're 50 or older. Now, you put an extra 1000 in, so you have up to 7000 per year. Now, restrictive on another way because the money's got to be in there for at least five years before you can withdraw the earnings.
Speaker1:
It's called the five year rule on Roth IRAs. They also restrict the amount that you can earn in order to put into a Roth IRA. Let's say we'll go back to the married filing jointly versus single. If you're a single taxpayer, you can earn up to $139, $139,000 per year before being cut off of being eligible to put into a Roth IRA. So if you make above $139,000 per year, you can no longer contribute to a Roth IRA. If you're married, filing jointly up to 206,000 is your limit. If you earn above that, you cannot contribute to a Roth IRA for that given year. In fact, money that you've put into the account technically should be taken out if you've earned more in those years, right? If you put money into a Roth IRA in a year in which you've made more than you're able to. The money probably has to come out. So it's important to note the restrictive nature of a Roth IRA. It's still a good account, but they restrict the amount you can put in, how long the money has to sit there before you can pull out earnings and how much you can earn in order to participate or contribute to a Roth IRA. Now there's a lesser known but pretty valuable way in which you can also put aside funds that have already been taxed. Money can grow tax free, and you can take the money out on a tax free basis in the future.
Speaker1:
It's using cash value, life insurance, or, as I've listed here, my favorite type of cash value. Life insurance is called an index universal life plan. Now, how does this work? Well, again, money's already been taxed. If the life insurance plant, if set up properly, can promote maximum cash value growth over time. It is a life insurance plan. So there's a death benefit, tax free death benefit. Now, this is a lesser known strategy. It's also called a Super Roth. Why is that? Or a Roth IRA on steroids? Why is that? Because there are no restrictions on how much you can put in per year. There are no restrictions on how long the money has to stay in there before you can start pulling it out. There are no restrictions on how much you can earn per calendar year to contribute to you. So it kind of pulls some of the training wheels off, some of the restrictions off. So you can put as much as you want in. Now there is one restriction you need to qualify. Health wise, it is a life insurance plan. So if you can qualify, if you're in relatively good health, this plan could be or might be right for you. It is not right for everybody. I have a few of these and it doesn't mean that since I have it, it's right for you. I've just seen personally the benefits of this type of plan and the reasons why it's it works, why it's beneficial for me, my family, and my situation.
Speaker1:
Now I'm going to switch gears a second because and talk a little bit more about this outside of the Fed market. I sometimes call it the best retirement strategy. You've never heard of this IUL. It's extremely popular with high net worth individuals, CEOs and other people that maybe make too much money and able to contribute to a a typical tax free plan like a Roth IRA. Maybe they want to put in a lot more money. Perhaps they also want the the death benefit portion. But they see the benefits of this. It's very popular with college football coaches. This is something that is commonly thrown on the back end of their contracts as deferred compensation and a way that they can get tax free income down the road. The awesome part about an IUL or this type of tax free retirement strategy outside of the restrictions also is the fact that if something happened to me in the short term, my family is going to get a tax free death benefit in excess of the money that I put into the plan. And if I live too long, if it goes away, I exactly planned it. And now I want to take money from it in retirement or pre retirement, whatever it might be. I can do so on a tax free basis with an IUL.
Speaker1:
There are no restrictions on when you can access the money, so less restrictions. You just have to qualify health wise. Now we can run different scenarios so you can see exactly what that looks like. We start with a dollar amount that you're looking to put aside and we can run from there and make sure the plan is designed properly. You can tell us, hey, this looks right for me. I think this is a is a home run. Let's go forward with it. Or there are ways to set up a Roth IRA, if you'd rather go in that direction. The way to know if you're going to need to do something either with a supplemental account or a tax free account, or you need to mitigate your tax liability is to get an analysis done is to have us go through your personal benefits and retirement situation, see where you currently stand. Run the numbers for when you're looking to retire so you can, number one, see if you're going to have enough money in retirement. Number two, if you're going to want to mitigate your tax liability in retirement. And three, if you decide that you need to set aside additional funds for the future, well, do you want those to be in a taxable account or do you want them to be in a tax free account? Do you want them to be in a risky account? Do you want them to be in a risk free account? Risk free plus tax free? Maybe a combination of both.
Speaker1:
So that's the way that we know that if, number one, you're going to be in a similar tax bracket in retirement. We're just going to run your analysis. Number two, we're going to find out if you're going to need to provide additional money for the future and if you want that money to be tax free. I will mention something else, because I can I can almost hear the questions that are coming out. Well, now, look, I don't have too much time left until retirement. I don't have the time to contribute to a Roth IRA or to one of these life insurance plans or I've already got money saved up. I've got IRAs. For one case, my TSP, you know, I'm pretty much set. How do I turn those monies now into a tax free retirement? So up to this point, we were saying, well, if you have a time horizon, you have time until retirement. You can accumulate additional funds in a supplemental type account and make that account be tax free. But what if you've already built up the assets? Well, you can still do or have a Roth IRA. Now, this is through a Roth conversion, also known as a backdoor Roth. So I mentioned that Roth IRAs earlier are restrictive. They restrict your income level. They restrict the amount you can put in there. They restrict how long the money has to be in there and how old you have to be to take out the earnings in the Roth IRA.
Speaker1:
We can eliminate some of those restrictions with what's called a backdoor Roth, a Roth conversion. Now, this is where you take your already pre-tax money. Let's say you've put money in an outside 41k and you no longer work with that company and you have the ability to do something with it. And you're saying, Well, I want to turn this money into tax free money. Right now it's pre-tax. How can I turn it into tax free money? Well, that's where the Roth conversion comes in. I'll give you an example. Talk to a federal employee. A federal employee had a uniformed services account, was a prior military, had a uniformed services TSP. And this particular employee wanted to convert that money to a tax free account. They wanted to do a Roth conversion. Now, how would this work? Well, you would take your pretax money, your pre-tax, traditional qualified money. One day it'd be pre-tax. The next day it would be tax free just like that. The only problem with a Roth conversion is you have to pay the taxes up front. So you're going to have to now have a tax liability or a tax bill. You're going to pay the taxes after you convert the money. So you're basically saying, look, Uncle Sam, I know you're in my pocket. I want to get you out of my pocket.
Speaker1:
I'm going to pre-pay you what I owe you. Now, that way, going forward, all the earnings that I gained in this account are going to be gained and then ultimately withdrawn on a tax free basis. But you have to prepay the tax now so you can do this in two ways. If you have a qualified account again, a previous 41k, a uniform services TSP or some other qualified account that you want to turn into tax free money, you can do this in a lump sum. Let's use an example. Let's say it was 100,000. And you're saying I want to I want to convert it. Well, 100,001 day will be pre-tax. The next day will be tax free. You're going to have to pay the tax bill, though, at the end of the year. And whatever tax bracket you're in, that's what you're probably going to owe on the 100,000. It might actually bump you up into a higher tax bracket because that's going to be pushing your total taxable income up. But you have to pay the taxes in a lump sum. If you're saying, well, I don't want to do that in a lump sum, is there any other way? Option number two is to do partial Roth conversions. So there have been times I've helped folks that say, well, I've got $100,000, I want to pay those taxes over five years. So can we do a partial conversion over five years? Sure.
Speaker1:
Let's do 20,000 a year for five years. You're going to pay tax each year on the 20,000 you convert, and then after five years, the whole account will be converted. Pretty awesome stuff, right? So that's a way that you can do it over time. You can also get a little crafty, talk to your CPA, your tax person, and say, How much more can I earn this year before bumping up into the highest tax bracket or higher tax bracket? And we can stay at that level each and every year. It doesn't have to be a uniform amount. And that way you're staying within the current tax bracket, not getting bumped up or bumped up to high. So you can turn already qualified pretax money into tax free money, just understanding that you're going to have to prepay the taxes. But as I said, you pay off Uncle Sam early. Now, any earnings that you have going forward are going to be applied and you can withdraw the money plus the earnings on a tax free basis. You know, reach out to us. Let's do a benefits analysis. Let's go over your situation, see where you currently stand. And if if starting a tax free retirement strategy is going to be right for you, I appreciate you listening and tuning in to this episode of the Federal Retirement Show, so make sure to subscribe, watch our previous episodes, leave us a rating and looking forward to seeing you on a future installment.
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