FERS Stool vs FERS Recliner
FERS 3-Legged Stool vs. FERS Recliner: Where Will You Sit In Retirement?
I recently asked this question at one of my FERS pre-retirement seminars and saw many confused faces peering back at me. “What do you mean?” was the collective telepathic response. “Well, income continuation can be designed with purpose, can be planned out, and income for a surviving spouse can come in a number of different ‘flavors’”, I then asked again, “What kind of income do you think your spouse would like if you were to pass away?”
Now, grasping more of the context behind the question, I started getting a litany of different responses. Some people offered percentages to continue, some dollar amounts, some wanted guaranteed incomes, one gentleman just yelled ‘BIG!’, while others said to leave a lump sum that loved ones could live off. There were nearly as many ideas about how to best help one’s spouse as there were married people in the room.
Having repeated this exercise with different agencies around the country, we have heard many well thought out answers and we have helped even more families find their own personal solutions… but there is one approach that I have never heard, one answer that many Federal employees unwittingly employ but absolutely no one has ever shouted out.
When asked, “What kind of income would your spouse like?” no well-intentioned federal employee has ever yelled, “TAXABLE!”.
Now, admittedly, there was one divorcé who voted to change her answer at that point, but I digress…
No seriously, no one has ever been excited to pay avoidable taxes, especially the single-income households of elderly surviving spouses. So, I then asked, “IF given the choice, would your spouse elect to receive income that is taxable or tax-free?”
Edison would have been blinded by the lightbulbs suddenly turning on. “That is a no brainer – we would choose the tax-free income all day, every day, and twice on Sundays!”
Very few rules in personal finance are universal, hence the word personal, but one universal truth is that we all want to avoid paying more than our fair share in taxes. We can all agree that ceteris paribus, or all other things being equal, we all want to minimize our tax liability as much as legally possible!
So, why then do so many federal employee’s leave ONLY taxable incomes to their surviving spouse?!?
Well, most feds are only taught about income continuation through the Surviving Spouse Benefit from OPM, which continues a portion of your retirement pension to your surviving spouse should you pass before them. Rarely are we taught to weigh the tax implications of this approach in comparison to alternative strategies. Now the SSB is essentially an inflexible version of a life insurance policy – you reduce your pension (aka pay premiums) during your life to have a benefit paid to your beneficiary (surviving spouse) for the rest of their life should you pass. I have written another article expanding on this comparison but, in this piece, we will stay focused on the difference between the way the IRS views a Death Benefit from life insurance (tax-free) and a pension continuation benefit like the SSB (almost entirely taxable). Now there are times when the SSB is a necessity (primarily when FEHB continuation to the surviving spouse is a must) and there are times when the SSB may be the most cost-effective option (primarily when the retiree is uninsurable), but there is never a time when the SSB receives the tax advantages that life insurance proceeds receive.
Thus, it is only with purposeful planning that we can create tax advantages for our loved ones in the future. Uncle Sam intentionally limits the ways in which you can experience financial gains that do not trigger a tax and, as our national debt careens out of control, it is important to keep in mind that they can change those tax rules to support even more aggressive government spending at any time.
With life insurance, many know that the Death Benefit is paid out 100% tax-free but wrongfully believe that the only payout option for that death benefit is a lump sum paid all at once. While electing a single payment can work perfectly well in certain situations, understand that doing so then burdens your spouse with the responsibility of investing that lump sum in a way that allows them to sustain their lifestyle indefinitely. Understandably, many spouses struggle under the weight of that task, especially if they were not already the ‘Family CFO’ accustomed to managing the family finances. Even in the best of times, people rarely tell me that their favorite Sunday morning read is ‘the checkbook’… so it is no shock that in the emotional aftermath of losing a loved one it is extremely difficult to make sound financial decisions. Further reason creating a plan beforehand is so imperative.
Soooo, what if you could design a survivor’s income continuation plan that guarantees your spouse could never outlive the monthly payments AND that made the majority of every payment tax-free?
Not only can that be done, payments can be contractually guaranteed for life – no relying on investment returns or market cycles!
What if your surviving spouse only out-lived you by a few months?
With the right design, we can name a Contingent Beneficiary to receive the balance of any remaining benefit should your spouse pass early – ensuring someone you care about receives the benefit you paid for. With the inflexible SSB, there is only one person who can receive benefits – the surviving spouse. No one else. If you pay in more than you spouse lives long enough to get back out then your family is simply out of luck.
What if you found yourself as the Surviving Spouse?
Well, like we just said, the SSB can only benefit a spouse – so if you were to lose your spouse then you also lose a lot of money (everything you have paid in to be exact). Not a comforting thought during those terrible times. Salt, meet wound. Whereas when you design your own plan, you could elect to leave a legacy to other beneficiaries or access the policy cash values yourself to supplement your own income (also tax-free!). If your crystal ball is not working, this sort of flexibility is key!
Additionally, leaving your partner with a taxable income stream (like that offered by the SSB) can actually increase the taxes they owe on other streams of income as well. Taxes beget more taxes! Read that again. Widows/widowers on Social Security that bring home more than $25,000 of taxable income are subjected to tax on up to 50% of their Social Security Benefit. More than $32,000 of IRS recognized income will require said widow/widower to pay income tax on up to 85% of the benefits they receive from Social Security. Having already paid Social Security tax on your salary over the course of your career, why should your spouse have to pay income tax on those benefits again if you had another option? If you designed a plan that limits the amount of what the IRS views as taxable income, while still providing ample cash-flow, then your spouse’s Social Security Survivor Benefit could also be 100% tax-free! That could mean thousands upon thousands of dollars in savings… each and every year!
At what rate would my surviving spouse’s taxable income be taxed at in the future?
With our ballooning national debt and deepening political derisiveness, we have no idea what those rates could climb to during your retirement. But if the third leg of your ‘Surviving Spouse’s 3-Legged Retirement Stool’ is a Traditional (tax-deferred) TSP, then that too will generate a tax bill anytime those funds are needed… at whatever rates Uncle Sam deems necessary at that time. As you can now see, altogether too many surviving spouses find themselves at risk of having to reduce their life style in order to pay higher tax rates out of their survivor’s fixed income.
Without forethought, the taxation of your surviving spouse’s income could come to decimate their quality of life as taxes try to catch up to our government’s appetite. Remember, it is not the income you get, but the income you keep (after tax) that dictates the lifestyle you and your family can afford. As such, it could not be more imperative that you understand your planning options ahead of time –AVOIDING taxes and EVADING taxes are two very, very, VERY different things. Strategically avoiding extra taxes is perfectly legal, evading taxes is absolutely not. It is only with careful planning that we can design you and your spouse’s retirement plan to avoid the heavy burdens of taxation. If you would like to learn more about designing a tax-efficient retirement plan for both you and your family, please feel free to contact us today!
Disclaimer: This material is for information purposes only and is not intended as tax, investment, or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation as these matters can be quite complex.