Taxation of Federal Payments and Benefits
Refund of Contributions Upon Leaving Government Service
An employee leaving government service prior to retirement can choose to receive a refund of the money credited to his or her retirement fund. If the refund includes only the employee’s contributions, then none of the refund is taxable. If it includes any interest, the interest 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.
An employee who transferred from the Civil Service Retirement System to the Federal Employees Retirement System with less than five years of service under CSRS may have received a refund of the additional money paid for the CSRS service, plus interest. The interest received on this type of refund is taxable and cannot be rolled over.
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 contributions to the retirement plan (CSRS or FERS). These contributions were previ- ously 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 retiree’s month- ly annuity.
•The taxable balance. The taxable balance represents the federal government’s contribution to the retirement plan as well as any earnings in the plan. Taxpayers must use the General Rule or, if they qualify, the Simplified General Rule to compute the taxable portion of their annuity payments.
General Rule—If a retiree’s annuity starting date was after July 1, 1986, and before November 19, 1996, then the retiree can choose to use either the General Rule or Simplified Method to determine the tax-free portion of the annuity. If the annuity starting date is after November 19, 1996, then the retiree cannot use the General Rule. Under the General Rule, a retiree will figure the tax-free portion of each full monthly payment by multiplying the gross monthly annuity by an exclusion percentage. The exclusion percent- age must be 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 the appropriate actuarial table for the retiree’s life expectancy. The calculation is complex and retirees who need help as well as access to the actuarial tables and more information about the General Rule should obtain IRS Publication 939, General Rule for Pensions and Annuities (available at www.irs.gov).
Simplified General Rule—This rule may be used if a retiree’s annuity starting date was after July 1, 1986. The rule must be used if one’s annuity starting date is after November 18, 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 General Rule, the tax-free portion of each monthly payment determined by dividing the retiree’s cost in the plan, as furnished by OPM, by a certain 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.
In the case of a non-“Alternative Form of Annuity” (AFA), any “deemed” deposits or redeposits are not added to a 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 utilized 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 US Civil Service Retirement Benefits, available at www.irs.gov).
Taxpayers with an annuity starting date after July 1, 1986, can change the method of computing the tax-free portion of their annuity from the General Rule to Simplified General Rule or vice versa (if the annuity starting date was before November 19, 1996, and the General Rule was selected). In order to change methods taxpayers will have to file amended tax returns for all tax years beginning with the year in which they received their first annuity payment. Due to the statute of limitations on filing amended tax returns, tax- payers can only change methods within three years from the due date of the tax return for the year in which the taxpayer received the first annuity payment or, if later, within two years from the date the tax for that tax year was paid.
Regardless of whether the General Rule or the Simplified General Rule 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).
For information on Thrift Savings Plan withdrawals, including tax implications, see Chapter 6, Section 4.
Lump-Sum Benefit Payment (Alternative Annuity Option)
Certain individuals who retire under CSRS or FERS 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. The option is only available to 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.
Under the alternative 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.
However, if the employee is covered by CSRS or by FERS with a CSRS component and the employee received a refund of CSRS contributions for a period of service that ended before Mar. 1, 1991, he or she will be allowed credit for that service, subject to an actuarial reduction in the annuity, without paying a redeposit. If the employee elects an alternative annuity under these circumstances, the amount of the redeposit is not considered a “deemed” redeposit, and is not included in the amount of the lump-sum payment reported to the IRS. Also, post-1956 military service credit deposits are not deemed made under the AFA provisions. They must be paid to the employing agency before separation.
A retiring employee must include the taxable part of the lump-sum payment in income for the year it is received unless the employee rolls it over into another qualified retirement plan or into a traditional IRA. The OPM is required to withhold federal income tax at a 20 percent rate on the taxable portion of the lump-sum payment unless the employee requests OPM transfer that portion directly to a qualified retirement or to a traditional IRA.
Taxability of Federal Life Insurance Benefits
Death benefit payments made under Federal Employees’ Group Life Insurance (FEGLI) to a designated beneficiary are not taxable as income to the beneficiary. As with any life insurance policy in which the decedent had maintained incidents of ownership (the right to change the beneficiary), the proceeds are includible in the insured’s estate and may be subject to estate tax to the extent the estate is taxable.
“Living benefits” or “accelerated benefits” are life insurance proceeds paid by the insurance company, including FEGLI and many privately owned life insurance policies, to the terminally ill or medically incapacitated policyholder. These proceeds are income tax-free.
Government-Provided Business Reimbursements
Reimbursed Employee Business Expenses—If an employee does not receive a per diem or the fixed allowance, reimbursed employee business expenses will not be deductible from adjusted gross income unless the following conditions are met:
• The employee must substantiate the expenses covered by the reimbursement arrangement to the employer.
• The employee must return any reimbursement in excess of substantiated expenses. If these requirements are not met, all reimbursements must be included in income and expenses may be deducted only as a miscellaneous itemized deduction subject to the 2 percent of adjusted gross income limitation. Meals and entertainment expenses are subject to a 50 percent limitation prior to applying the 2 percent limitation.
Transportation and per diem allowances received by a federal employee are deemed substantiated. Therefore, there is no excess retained by the employee from the fixed allowance. If expenses exceed the fixed allowance, a deduction is allowed as a miscellaneous itemized deduction subject to the 2 percent of adjusted gross income floor.
In order to claim a deduction for non-reimbursed employee business expenses, Form 2106, Employee Business Expenses, must be completed by the taxpayer and attached to his or her tax return. Detailed records and substantiation are required.
Mileage—The optional standard mileage rate for deducting business automobile expenses, as set by the IRS was 54 cents per mile for 2016. For income tax purposes, actual expenses or the optional mileage method may be used for computing business deductions. If actual expenses are claimed, the business percent- age is based on business miles relative to total miles driven during the calendar year. In this situation, the amount the government reimbursed would offset the expenses claimed and the excess is reported as a miscellaneous itemized deduction, subject to the 2% of adjusted gross income floor.
Rural Mail Carriers—A rural mail carrier who receives a qualified reimbursement of expenses incurred for the use of his or her vehicle for performing the collection and delivery of mail on a rural route is allowed a deduction for an amount equal to the qualified reimbursement received. The reimbursement is treated as being paid under an accountable plan and is excluded from gross income. The special standard mileage rate and provisions related to its use by rural mail carriers have been repealed.
Federal Employees Engaged in Criminal Investigations—The travel expenses incurred by a federal employee engaged in a criminal investigation away from home are fully deductible regardless of the length of time spent away from home. In order to qualify under this special provision, the employee must be certified by the Attorney General or her delegate as traveling on behalf of the United States on temporary duty status to investigate or provide support services for the investigation of a federal crime.
Military Pay and Benefits
Generally, members of the U.S. Armed Forces include the same items in income as do civilians. Certain pay and benefits resulting from service in the Armed Forces are exempt, as follows:
Armed Forces Benefits—Retirement pay received from the government by Armed Service members is not exempt from income tax. Disability retirement pay that is computed on the basis of the percentage of disability is fully excludable from gross income, but disability retirement pay that is computed by reference to years of service is excludable only to the extent allowed under the percentage-of-disability method. Any pension, annuity, or similar payment for personal injury or sickness that resulted from combat related service in the armed forces of any country or in the Coast and Geodetic Survey or the Public Health Service of the United States is exempt from tax.
Veterans’ benefits under any law administered by the Veterans Affairs Department are not includible in income. This includes amounts paid to veterans or their families as educational, training, or subsistence allowances, grants for homes with wheelchair access, and grants for vehicles for veterans who lost their sight or use of their limbs.
Dividends and proceeds from maturing government endowment insurance contracts under all acts relating to veterans are exempt. Interest on dividends left on deposit with the VA is also exempt.
Armed Forces Allowances—Allowances for subsistence, quarters, travel, and moving paid to any member of the Armed Forces, Coast and Geodetic Survey, or Public Health Service, are excludable from income. These include housing and cost-of-living allowances to cover the excess cost of quarters and subsistence while on permanent duty at a post outside the United States, as well as family separation allowances received on account of overseas assignment.
Combat Zone Compensation— Compensation received by an enlisted member of the Armed Forces is excluded from the taxpayer’s gross income for any month during which the taxpayer served in a combat zone or was hospitalized as a result of wounds, disease, or injury incurred while serving in a combat zone. The exclusion for months of hospitalization does not apply for any month beginning more than two years after the termination of combatant activities in the zone. For a commissioned officer, the exclusion is limited to “the maximum enlisted amount.” This amount is the highest basic pay rate at the highest pay grade that enlisted personnel may receive plus the amount of hostile fire/imminent danger pay that the officer receives.
Compensation other than basic military pay that is excludable includes such items as:
- compensation for annual leave earned by an enlisted member of the Armed Forces while serving in a combat zone, though no services are performed by the member of the Armed Forces in a combat zone in the year of payment;
- a cash award received by an enlisted member of the Armed Forces for an employee suggestion that he submitted while serving in a combat zone, even though the award was granted and received outside of the combat zone; and
- an enlisted member’s bonus for re-enlisting while serving in a combat zone, even though the re-enlistment bonus was received outside of the combat zone.
Generally, the time and place that the military compensation was earned determines excludability, not the time and place of payment.
Taxes Due from Member of Armed Forces Upon Death—If a member of the Armed Forces dies while serving in a combat zone or as a result of wounds, disease, or injury while so serving, the income tax for the year of death and any prior year ending on or after the first day served in a combat zone is canceled. Any unpaid taxes of such individual that relate to tax years prior to service in a combat zone may also be abated. A similar rule applies to U.S. military and civilian employees who die as a result of wounds or injury occurring outside the United States in a terrorist or military action against the United States or any of its allies.