When planning for federal retirement, it can be easy to buy into ideas one hears. Certain “facts” are mentioned at the coffee station and all too often are simply accepted as true. An effective retirement plan cuts through these surface level beliefs and attempts to examine what’s really in store once federal employment ceases. In a recent post, we looked at the retirement myths of having a guaranteed decrease in living and leisure expenses in retirement. For a quick refresher, click here. Let’s continue our discussion with a widely accepted belief about taxes in retirement.
Retirement Myth #2:
I will fall in a lower tax bracket in retirement due to a decrease in income.
Based on RBI’s experience working with federal employees, we have found that depending on age and years of service, retirees will receive between 40-80% of their salaries in retirement. This leads to the expectation of having reduced taxable income that will result in a lower tax bracket in retirement. If you have made this assumption in your retirement planning, rest assured; you are not alone. Here are a few tax implications that you may see as a retired federal employee.
Addressing the Income Gap
A wise consumer should evaluate one’s net income in retirement and compare it to net pay while working. Often a retiree finds a financial gap that needs to be filled to maintain the same standard of living. Where will these funds come from? Options may exist to begin drawing Social Security or the Special Retirement Supplement benefit. Some may choose to begin accessing funds that were contributed throughout employment to the Thrift Savings Plan (TSP). While Traditional TSP is a great savings vehicle, it is tax deferred. Employee contributions, the government contributions (for FERS only), and any growth made during the lifespan of the Traditional TSP, will be taxed upon withdrawal. Although we cannot predict future tax brackets, we can take a look at the current and ever-changing national debt. Many would assume that taxes may increase for prospective taxpayers.
Taxes Now or Later?
At Retirement Benefits Institute, we generally find that federal employees are at the top of a tax bracket while working. Then they find themselves at the bottom of that very same tax bracket in retirement before any withdrawals from TSP are made. As a result, they are required to pay additional taxes and have the need to make withdrawals from their traditional TSP. This proposes a few questions for the future retiree:
- Would you rather pay taxes now, or in retirement when your bring-home pay is less?
- How can you help reduce the impact of taxes in retirement?
Educating yourself on the investment vehicles available to you before retirement may be beneficial and help answer these questions.
As a federal employee, you also have the ability to contribute to a Roth TSP account. This account contains the same funds as the Traditional TSP: G, F, C, S, I and L. You may distribute your contributions throughout the funds as you please, while not exceeding the contribution limits. For FERS employees contributing to Roth TSP, your government match will be contributed to your Traditional TSP, but nonetheless you will still receive your match. Roth contributions are made with after-tax dollars and your contributions, as well as your gains generally may be withdrawn tax free! This allows you to pay taxes on the dollar now as opposed to waiting until retirement.