Is FERS Disability Retirement Taxable?
Navigate the tax rules for FERS disability benefits. Learn how the taxable amount changes over time based on your age and your after-tax contributions.
Receiving Federal Employees Retirement System (FERS) disability retirement provides income when a medical condition prevents a federal employee from working. The tax treatment of these benefits is a common concern, as the rules change based on the recipient’s age. This shift in tax status from disability income to a retirement annuity occurs when you reach your Minimum Retirement Age (MRA) and affects your overall financial picture.
Tax Treatment Before Minimum Retirement Age
Until a recipient of FERS disability retirement reaches their Minimum Retirement Age (MRA), the Internal Revenue Service (IRS) treats the payments as disability income. For tax purposes, this income is considered a substitute for wages and is taxed as ordinary income at the recipient’s applicable federal income tax rate.
During this period, the income is not considered “earned income” for making contributions to an Individual Retirement Arrangement (IRA). However, recipients may be eligible for the Tax Credit for the Elderly or the Disabled, a non-refundable credit designed for individuals retired on permanent and total disability. To qualify, you must meet specific income limitations and have received taxable disability income.
The credit is calculated on Schedule R, Credit for the Elderly or the Disabled, and can reduce your overall tax liability. The amount is based on your filing status and is reduced by certain types of non-taxable income, like the non-taxable portion of Social Security benefits. Eligibility is determined annually while your benefits are classified as disability income.
Tax Treatment After Reaching Minimum Retirement Age
The tax treatment of your FERS disability payments changes on the day you reach your Minimum Retirement Age (MRA). Your MRA is determined by your birth year and is the earliest age you could have voluntarily retired, falling between age 55 and 57 for most FERS employees. For example, an individual born between 1953 and 1964 has an MRA of 56.
On the date you reach your MRA, the IRS reclassifies your payments from disability income to a regular FERS retirement annuity. This mandatory change in tax status allows you to begin recovering your after-tax contributions to the FERS retirement system. This recovery creates a tax-free portion of your monthly annuity.
The tax-free portion of your annuity is calculated using the IRS’s Simplified Method, which spreads the recovery of your contributions over your expected lifetime. To find the tax-free amount of each monthly payment, you divide your total after-tax contributions by a number of months from an IRS table. This number is based on your age, and your spouse’s age if you elected a survivor benefit, when your annuity begins.
For instance, a single retiree aged 61 with $40,000 in after-tax contributions would divide that amount by 260, the number from the IRS table for that age. This results in a monthly tax-free amount of $153.85. This portion of the annuity is not subject to federal income tax until the full $40,000 has been recovered.
Once your total contributions have been recovered tax-free, all subsequent annuity payments become fully taxable. At this point, your income is treated as a pension, and eligibility for the Tax Credit for the Elderly or the Disabled ceases.
State Income Tax Rules
Federal tax rules for FERS disability retirement do not automatically apply at the state level. Each state has its own laws for taxing retirement and disability income, creating a wide variance across the country. Where you live in retirement can directly impact your net income.
State approaches to taxing this income vary significantly. You must investigate the specific tax laws of your state of residence, but states can be grouped into several categories:
- States with no personal income tax.
- States that fully exempt all federal pension and disability income.
- States that offer partial exemptions or tax credits, which may be based on age or income thresholds.
- States that fully tax FERS disability and retirement annuity payments.
Reporting FERS Disability Income on Your Tax Return
Each year, the Office of Personnel Management (OPM) will send you Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, etc. This form reports the total amount of FERS disability income you received during the year and is necessary for completing your federal income tax return.
Key boxes on Form 1099-R include Box 1, which shows the gross distribution, and Box 2a, which indicates the taxable amount. Box 7 contains a distribution code that tells the IRS the nature of the payment. Before you reach your MRA, Box 7 will show Code 3, signifying a disability payment, and will change to Code 7 for a normal distribution after you reach MRA.
When filing your tax return before reaching MRA, the taxable amount from Box 2a of your Form 1099-R is reported on the line for wages, salaries, and tips on Form 1040. This is consistent with the treatment of the income as a substitute for wages.
After you reach your MRA, the reporting location changes. The gross distribution from Box 1 is reported on the line for pensions and annuities, and the taxable amount from Box 2a is reported on the corresponding line for the taxable portion of those benefits.