How Federal Employees are Taxed in Retirement: Part Two

How Federal Employees are Taxed in Retirement: Part Two

Last week, we discussed how your pension might be taxed in retirement. But that probably won’t be your only source of income. Since federal employees enjoy a three-tiered retirement system, you might also be wondering whether you will owe taxes on distributions from your Thrift Savings Plan (TSP).

The answer seems simple on the surface: The decisions you made years ago, regarding your TSP contributions, will now dictate how your withdrawals are taxed in retirement.

If you chose to make traditional contributions… Most federal employees choose to make traditional contributions, meaning their contributions were taken from their paychecks on a pre-tax basis. This is often a smart decision, as it helps to lower your overall taxable income each year while helping you to save for retirement. Over the course of your career, those contributions also grew free of taxes. But, since you can’t escape income taxes forever, those withdrawals will be taxed as regular income in retirement. For most, this is not a bad deal, since we tend to stay in the same tax bracket or even drop down a bracket after we retire.

But if you chose Roth contributions…. You had another choice, though, to make Roth contributions to your TSP. These contributions are made on an after-tax basis, and they don’t help to lower your taxable income each year. However, they do help you to establish tax-free income for retirement. Since you already paid taxes on that money, you don’t owe taxes again when you take withdrawals from your TSP. Keep in mind that this rule only applies to “qualified” withdrawals: You have reached ate 59 ½, at least, and the money has been in the account for five years or more.

So, this part of your income taxes in retirement will depend upon decisions that you made years ago. Before you retire, schedule a meeting with us so we can discuss your potential income tax burden. You need to know what to expect, so that you can establish a budget and avoid any surprises. And, we can keep you informed of rules pertaining to your retirement benefits, so that withdrawals don’t accidentally trigger extra tax penalties.