4 Tax Pitfalls Federal Employees Need To Avoid

There are many financial mistakes that federal employees can make throughout their life, but some of the most common that I see revolve around tax planning.

Specifically, there are 4 common errors I see federal employees make before they work with my firm. These tax mistakes can be costly and might even derail your financial plan if not avoided.

So, whether you’re many years away from retirement or just around the corner from the last clock in, make sure you plan to avoid these 4 tax pitfalls.

1: Not Knowing Social Security Taxation Rules

Some federal employees are surprised to learn that their Social Security benefits might be taxable. But up to 85% of your benefits can be subject to taxation if your income exceeds the combined income thresholds.

Here are the combined income thresholds for 2021:

If your combined income is less than $25,000 ($32,000 for married couples filing a joint return), your Social Security benefits are tax-free.

If your combined income is between $25,000 and $34,000 ($32,000 and $44,000 for joint filers), then up to 50% of your benefits are taxable.

If your combined income is more than $34,000 ($44,000 for joint filers), then up to 85% of your benefits are taxable.

To determine your combined income, take your modified adjusted gross income, add 50% of your Social Security benefits for the year, and add all tax-exempt interest income, such as interest received on municipal bonds.

Read this article to learn more about Social Security

2: Not Planning For The Medicare Surcharge

Unlike Medicare Part A, which is free, there is a monthly premium for Part B. Most federal employees who sign up for Medicare Part B will pay the standard monthly premium, which in 2022 is $170.10 per month per person.

However, you will pay a higher premium if your modified adjusted gross income (MAGI) from two years prior was above the threshold ($91k for single taxpayers and $182k for married couples in 2022). If your MAGI exceeded the threshold, you’ll pay the standard premium amount plus an Income Related Monthly Adjustment Amount (IRMAA).

4 Tax Planning Pitfalls Federal Employees Need To Avoid

For example, if you file a joint return and your MAGI from two years ago was above $182k but below $228k, your Part B premiums would increase from $170.10 to $238.10. That’s an additional $816 a year per person. This additional cost is, in my opinion, another tax that could have been avoided with proper planning.

3: Not Planning For RMDs

As I covered in last week’s article, Required Minimum Distributions (RMDs) are a significant part of retirement planning that, if not considered, can lead to a higher tax bill.

This is because the mandated annual distributions from your TSP and other tax-deferred accounts can cause you to withdraw more money than you need each year. While you can invest the money back in your non-retirement brokerage account, you’ll still have to pay taxes on the distribution.

Moreover, if the RMDs blindsided you, they might push you into a higher tax bracket. So not only will you have to pay taxes on more money than you initially planned for, but you also might have to pay taxes at a higher rate.

4: No Tax Diversification

One of the most significant ways to reduce your lifetime tax bill is by contributing to the three different account types (tax-deferred, tax-exempt, and taxable) to create diverse tax buckets. Having these accounts at your disposal will allow you to deploy a dynamic withdrawal strategy in retirement.

This strategy might look something like this: first, you’d fill up your lower tax brackets with your tax-deferred withdrawals, followed by withdrawals from your taxable account that will benefit from the preferential long-term capital gains rates. Lastly, you could withdraw from your tax-exempt account without being bumped into the next tax bracket.

The misstep many federal employees make is that they fail to build diverse tax buckets, which prevents them from utilizing a dynamic withdrawal strategy in retirement.

Most only consider their current tax liability and thus contribute to the traditional TSP exclusively, or they focus solely on lowering their tax bill in retirement by only contributing to the Roth TSP.

This lack of diversification often results in not only a larger lifetime tax bill but also taxable Social Security benefits and higher Medicare premiums.

Read this article to learn more about tax diversification

Final Thoughts

Understanding and avoiding these tax pitfalls is critical to the longevity of your financial plan. By being proactive with your planning, you’ll be able to take advantage of opportunities to minimize taxes and ensure you’ll have the retirement income you need and want.

Although every federal employee can benefit from avoiding the pitfalls covered, every person’s situation is different, and the exact planning steps you should take will depend on your financial situation and goals.

Lastly, consult a fee-only Certified Financial Planner™ if you need help or aren’t confident in creating your financial plan.

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2023 Legislative Change Notice

The SECURE ACT 2.0 passed and impacted many of the articles on this website. While the articles were correct when written, it’s impossible to re-write every article. Please consult a qualified professional (i.e., CFP®, CPA, or attorney) before implementing any strategy.

Author: Jose Armenta, MsBA, CFP®, ChFC®, EA

Hi, I’m Jose Armenta, a Certified Financial Planner practitioner. For over 14 years, I have worked with or among federal employees, from serving in the Marine Corps to my stint as a police dispatcher and now as a financial planner specializing in helping FERS federal employees. In that time, I have spoken to hundreds of federal employees about their benefits and retirement. Helping federal employees maximize their benefits, reduce taxes, and live confidently is a passion of mine. When I am not perfecting financial plans, you’ll find me at the shooting range, playing the drums, or breaching blanket forts with my three little ones.