Is FERS Retirement Taxed by the Federal or State Government?
Unravel the nuances of FERS retirement taxation. Get clarity on how your federal employee benefits are taxed for smarter financial planning.
The Federal Employees Retirement System (FERS) is a retirement plan for many United States federal civilian employees. It provides benefits from a basic annuity, Social Security, and the Thrift Savings Plan (TSP). Understanding the tax implications of these FERS benefits is important for retirees transitioning from federal service.
Federal Income Tax on Your FERS Annuity
The FERS basic annuity is subject to federal income tax as ordinary income. A portion of the annuity payments, known as the “cost basis,” represents a return of the employee’s after-tax contributions. This portion is not taxed again. The remaining part of the annuity, including government contributions and earnings, is taxable.
To determine the non-taxable portion of your FERS annuity, the IRS uses the Simplified Method for annuities that began after November 18, 1996. This method calculates the tax-free amount by dividing total employee contributions (cost basis) by the total number of expected monthly payments. Expected payments are determined using IRS life expectancy tables, considering the retiree’s age at the annuity starting date. If a survivor benefit is elected, the calculation involves the combined ages of the retiree and the designated survivor.
The tax-free amount calculated using the Simplified Method remains fixed for each monthly payment, even if the annuity increases due to cost-of-living adjustments. Once the total cost basis is recovered tax-free over the retiree’s life expectancy, all subsequent annuity payments become fully taxable. Each January, the Office of Personnel Management (OPM) provides retirees with Form 1099-R, detailing the gross distribution, taxable amount, and non-taxable portion of the FERS annuity for the preceding year. This form is used for federal income tax returns.
State Income Tax on Your FERS Annuity
State income tax rules for FERS annuities vary significantly across the United States. Unlike federal taxation, no single approach applies to all states. Some states do not impose a statewide income tax, so FERS annuities and other retirement income are not subject to state taxation in those jurisdictions.
Other states offer full exemptions for FERS annuities. Some states provide partial exemptions, where only a certain amount may be excluded from taxable income, or the exemption applies only to retirees meeting specific age requirements. Any portion of the FERS annuity beyond these limits is subject to state income tax.
Some states fully tax FERS annuities as ordinary income, without offering specific exemptions or deductions. Federal retirees should consult their state’s tax laws to understand how their FERS annuity will be treated for state income tax purposes. This ensures accurate tax planning and compliance.
Taxation of Related FERS Benefits
Beyond the basic FERS annuity, federal retirees often receive income from other components of their retirement package, including the Thrift Savings Plan (TSP) and Social Security benefits. The TSP offers two primary account types: Traditional TSP and Roth TSP. Contributions to a Traditional TSP are made with pre-tax dollars, reducing current taxable income. Withdrawals from a Traditional TSP in retirement are taxed as ordinary income because both contributions and accumulated earnings have not yet been taxed.
Conversely, contributions to a Roth TSP are made with after-tax dollars. Qualified withdrawals in retirement, including all earnings, are tax-free. For a Roth TSP withdrawal to be qualified, two conditions must be met: the account holder must be at least 59½ years old, and at least five years must have passed since January 1 of the calendar year of the first Roth TSP contribution. Any matching contributions made by the employing agency are always allocated to the Traditional TSP, even if the employee contributes to a Roth TSP.
Social Security benefits can be subject to federal income tax, depending on the retiree’s overall income. The IRS uses “combined income” (also called provisional income) to determine taxability. Combined income is calculated by adding adjusted gross income, any non-taxable interest, and one-half of the Social Security benefits received. For individual filers, if combined income is between $25,000 and $34,000, up to 50% of Social Security benefits may be taxable; if it exceeds $34,000, up to 85% may be taxable. For those filing jointly, the thresholds are $32,000 to $44,000 for up to 50% taxability and over $44,000 for up to 85% taxability.
Tax Considerations for Specific FERS Situations
Certain FERS benefits, such as disability retirement and survivor annuities, have specific tax treatments. If a federal employee retires on disability, the disability annuity received from FERS is taxable as wages until the retiree reaches their minimum retirement age. Upon reaching this age, payments are reclassified as a regular retirement annuity, and the retiree may recover their cost basis using the Simplified Method. The IRS provides guidance on disability income in IRS Publication 525.
FERS survivor benefits, paid to eligible beneficiaries after the death of a federal employee or retiree, are taxable to the recipient. These benefits are considered ordinary income to the surviving spouse, former spouse, or children receiving them. Similar to the FERS retiree annuity, the survivor may recover the deceased employee’s after-tax contributions (cost basis) tax-free. The OPM calculates and reports the taxable and non-taxable portions of these survivor annuities on Form 1099-R.