Taxation of Federal Payments and Benefits
Refunds of Contributions
Federal employees leaving government service prior to retirement eligibility can choose to receive refunds of their required contributions into the federal retirement fund (see Chapter 8, Section 5 for the implications of making this choice and the policies regarding eligibility to elect a “deferred” annuity instead).
If the refund includes only the employee’s contributions, then none of the refund is taxable. Any interest portion is taxable unless it is rolled over into another qualified retirement plan or into a traditional IRA. It is important that the rollover be made directly from one plan to another without the employee actually receiving any portion of the amount being rolled over. Otherwise, the Office of Personnel Management is required to withhold federal income tax of 20 percent on the interest portion of the refund sent directly to the employee.
Taxability of Annuities
A federal retiree’s monthly annuity payment is composed of two parts:
• A tax-free portion that represents a return of cost. The cost is the total of a retiree’s required contributions to the retirement plan (CSRS or FERS) while employed. These contributions were previously taxed and included as income as part of an employee’s salary for federal and state income tax purposes and will not be taxed when received as part of a monthly annuity. The tax-free part is a fixed dollar amount. It remains the same even if your annuity is increased by cost-of-living adjustments.
• The taxable balance. The taxable balance represents the federal government’s contribution to the retirement fund as well as any earnings credited to the fund.
The statement you received from OPM when your CSRS or FERS annuity was approved shows the annuity starting date, the gross monthly rate of your annuity benefit, and your total contributions to the retirement plan (your cost). You will use this information to figure the tax-free recovery of your cost.
Taxpayers must use the General Rule or, if they qualify, the Simplified Method to compute the taxable and non-taxable portions of their annuity payments. If your annuity starting date is on or after November 19, 1996, you must use the Simplified Method. If your annuity starting date was on or after July 2, 1986 but before November 19, 1996, you generally could have chosen to use the Simplified Method or the General Rule.
Note: For annuities that began before July 2, 1986, a prior policy called the Three-Year Rule generally was used, with the General Rule available for those ineligible. The Three-Year Rule allowed recovery of the tax-free portion first, for up to three years, with subsequent payments being fully taxable.
Regardless of whether the General Rule or the Simplified Method is used, if the annuity starting date is after July 1, 1986, and the retiree and a survivor annuitant if a survivor annuity has been selected dies prior to recovering the entire annuity cost, the nonrecovered annuity cost is allowed as a miscellaneous itemized deduction not subject to the 2 percent of adjusted gross income limitation. This deduction would be included on the deceased taxpayer’s final income tax return (Schedule A, itemized deduction).
General Rule—Under the General Rule, the tax-free portion of each full monthly payment is calculated by multiplying the gross monthly annuity by an exclusion percentage. The exclusion percentage is calculated as of the annuity starting date, also known as the commencing date.
To determine the exclusion percentage, one must divide the adjusted investment in the contract—provided by OPM—by the expected return. The expected return is based upon the “discount” interest rate in effect at the annuity starting date under an actuarial table for the retiree’s life expectancy. See IRS Publication 939, General Rule for Pensions and Annuities, at www.irs.gov.
Simplified Method—This rule may be used if the annuity starting date was on or after July 2, 1986 and must be used if the annuity starting date is on or after November 19, 1996, and if the annuity payments are for either the life of the retired employee or for the life of the retired employee and a survivor receiving a survivor annuity.
Under the Simplified Method, the tax-free portion of each monthly payment is determined by dividing the retiree’s cost in the plan, as furnished by OPM, by a number based on the taxpayer’s age and a survivor’s age if a survivor annuity option has been chosen. The younger the retiree at the time of retirement and the younger the survivor annuitant, the higher the number divided into the cost in the plan. This means that there will be a smaller tax-free portion of the monthly payment.
Unless the retiree is eligible for and elects the “alternative form of annuity” (see below) any “deemed” deposits or redeposits are not added to the taxpayer’s cost in the retirement plan. If the taxpayer had withdrawn contributions from the retirement plan earlier, or if the taxpayer paid into the retirement plan to receive full credit for service not subject to retirement deductions, then the entire repayment—deposits and redeposits, including any interest paid—is part of the taxpayer’s cost.
A table detailing the number of months to be used in the calculation and examples are provided in the 1105 Media Inc. publication, Taxation of Federal Retirement Benefits (available at www.federalsoup.com) or in IRS Publication 721 (Tax Guide to U.S. Civil Service Retirement Benefits, available at www.irs.gov).
Tax Withholding—A CSRS or FERS annuity (including a disability annuity) is subject to federal income tax withholding, unless you choose not to have tax withheld. The choice for no withholding remains in effect until you change it. If you choose not to have tax withheld, or if you don’t have enough tax withheld, you may have to make estimated tax payments. You may owe a penalty if the total of your withheld tax and estimated tax falls below a penalty threshold. See IRS Publication 721 referenced above.
For information on tax withholding from Thrift Savings Plan withdrawals, see Chapter 6, Section 4.
Alternative Form of Annuity
Employees who have a life-threatening illness or other critical medical condition, and do not have a former spouse entitled to court ordered benefits based on the employee’s federal service, may elect to receive a lump-sum benefit payment equal to their total contributions to the retirement plan (see Chapter 3, Section 7). As a result of this payment, these individuals will receive a reduced monthly annuity.
Under this “alternative form of annuity” option, the lump-sum payment is composed of a tax-free part and a taxable part. The tax-free part represents part of the employee’s cost. The taxable part represents part of the employee’s earnings in the retirement fund. The lump-sum payment will include:
• All “deemed” deposits for federal employment during which no retirement contributions were withheld from pay plus interest.
• All “deemed” redeposits for any refunds of retirement contributions that have been received but not repaid plus interest.
The total of all “deemed” deposits and redeposits are included in the employee’s lump sum credit for purposes of computing the amount of the AFA annuity reduction.
A retiring employee must include the taxable part of the lump-sum payment in income for the year it is received, and federal income tax will be withheld at a 20 percent rate, unless the employee rolls it over into another qualified retirement plan or into a traditional IRA.
If you receive a lump-sum payment under the alternative annuity option you also will receive reduced monthly annuity payments. These annuity payments each will have a tax-free and a taxable part. To figure the tax-free part of each annuity payment, you must use the Simplified Method as described above.