Nine Tax Planning Tips for Retirement

Your guide to an essential part of the planning process.

This week’s column is guest-written by Bob Leins, CPA, president of the National Institute of Transition Planning.

Let’s face it. When the topic of income taxes comes up, there are few who get excited and many who want to turn the other way. But the fact is, income tax planning is essential when preparing for retirement. And if you break it up into individual parts, it’s a manageable task.

Here are some tax tips to consider as you plan for life after your federal career:

1. Know your federal and (if applicable) state income tax brackets. This is necessary to project your cash flow in retirement to meet your living expenses. Also, you should make sure your tax withholding is appropriate.

2. Plan carefully before withdrawing funds from your Thrift Savings Plan account. Should you take funds from the TSP to pay off a mortgage, or put a downpayment on a home? Most likely the answer will be no, because withdrawals from the TSP generally are fully taxable (with the exception of the new Roth TSP option). You may be better off looking at other options -- such as refinancing.

3. Remember that Social Security benefits are very income tax efficient. At the federal level, they are at most 85 percent taxable. And in many states, Social Security income is nontaxable. Suppose, for example, your Social Security retirement income at age 62 is $10,000 per year and 85 percent of that is taxable because you have other income from employment. If this income falls in the 25 percent marginal bracket, your federal tax would be $2,125. If you withdrew this amount from the TSP, all of it would be subject to income tax and most likely on both the federal and the state levels. On the other hand, it might make sense to wait until age 66 to apply for Social Security, because the benefit will be 25 percent greater than at 62.

4. If you are planning to retire early in the calendar year, think about “front loading” your TSP contributions. That means contributing up to the maximum elective deferral limit ($17,000 in 2012, plus $5,500 in catch-up contributions for those turning 50 or older) early in the year, since you won’t be able to contribute after retirement. If you’re going to start a new nonfederal job that also offers a retirement savings plan with matching employer contributions, then you may not want to do this so you can contribute to the new plan. Also, if you’re under the Federal Employees Retirement System, keep in mind your agency’s matching contributions. Decide on a contribution amount you are comfortable with since your increased contribution will affect your cash flow. If you do choose to front load your TSP contributions, take a look at your income tax withholding. It may be possible to decrease your withholding since the portion of your salary being invested in the TSP will not be subject to tax. Here’s a TSP fact sheet on these issues.

5. If you are considering moving to another state in retirement, study up on how that state treats retirement income. Some don’t tax annuities, some leave Social Security benefits alone and a few don’t touch TSP withdrawals. Here’s a list of state tax rules.

6. Initial federal annuity payments are subject to income tax at the federal level and in most states. Be aware that federal tax can be withheld from the initial annuity payments during the adjudication period -- the time during which your retirement is being processed. State income tax, however, is not withheld during this period. So you may have to save for the state tax that eventually will come due.

7. Be aware that employees and former employees can transfer certain funds to the TSP. These can include the taxable portion of traditional IRAs, 401(k) and 403(b) plans and retirement plans for the self-employed. Before requesting this type of transfer, make sure it makes economic sense for you.

8. Remember that part of your federal annuity is non-taxable. The Office of Personnel Management generally calculates the nontaxable portion on the Form CSA 1099R that you receive at the end of each tax year. Under some federal retirement systems, however, this calculation doesn’t occur automatically. For a full discussion of federal annuity tax issues, see Internal Revenue Service Publication 721. Retired federal law enforcement officers should pay special attention -- they are generally allowed a bigger tax-free benefit than other federal employees.

9. From a tax perspective, the best date to retire is the one that maximizes your federal benefits and your personal finances, while minimizing your income tax. I really like midyear retirement dates, assuming your main goal is not the maximum lump-sum annual leave payout at the end of the year. At mid-year, you will have six more months on the job with a higher salary than the annuity (in most cases), possibly a bigger high-three average salary and at least a small chance of a better tax deduction on your annuity. But the nicest advantage is front-loading TSP contributions. For more information, see Best Dates to Retire 2013 and Best Date to Retire Tips.

I want to thank Tammy for asking me to present these tips. I hope you picked up one or two you find useful. Happy tax planning!