Tax Strategies for Federal Employees Before Retirement

For a federal household the tax work concentrates in two places: the final working years, where income is at its highest and the annual leave payout lands, and the window between a retirement date and the start of required minimum distributions, where income is usually at its lowest it will ever be.

Why the timing is unusual

Most tax planning is a running exercise. For federal employees approaching retirement it compresses into a few years, because several things change at once and in opposite directions.

Your final working year is typically a high-income year, often higher than normal because the lump-sum annual leave payout lands in it. The year after, income drops to the annuity, possibly the supplement, and whatever you draw from the TSP. Social Security may not start for years after that. Required minimum distributions start later still.

That shape, a peak followed by a trough followed by a rise, is what creates the opportunity. Working out where your income sits in each of those phases is the whole exercise. This page describes the mechanics; the figures change annually and belong to your CPA.

This page is general information and is not tax or legal advice. Neither the firm nor its representatives may give tax advice. Contribution limits, brackets, surcharge tiers and distribution ages are set by federal agencies and change every year. Confirm all current figures with the IRS, the Social Security Administration or your CPA before acting.

Before you start

• Which system you are in, FERS or CSRS, and your service computation date
• Your latest annuity estimate and your intended retirement date
• Your TSP balance, split between traditional and Roth
• Your Social Security statement
• Any accounts held outside the federal system, and their tax character
• An estimate of what your annual leave payout will be

Without the traditional and Roth split in particular, none of what follows can be modelled. It is the single most common missing piece.

The final working years

Two things matter here. The first is TSP contributions. If you are in a high bracket now and expect a lower one later, traditional contributions in the final years are worth examining, and the catch-up provisions available at older ages raise the ceiling. The mechanical trap is front-loading: hitting the annual limit before December can end agency matching for the remaining pay periods, so spreading contributions usually captures more.

The second is the annual leave payout. It is taxable in the year it is paid, it lands on top of an already high income, and the retirement date determines which tax year receives it. Retiring near a year boundary moves that payout between years, and for a large balance the difference is not trivial. That is a conversation to have with your CPA before the date is set, not after.

The window before distributions begin

This is where the leverage is. Between your retirement date and the start of required minimum distributions, at 73 for most people approaching retirement now and 75 for those born in 1960 or later, income is usually the lowest it will be in your adult life.

Two things become possible. Lower tax brackets can be used deliberately rather than left unused. And Roth conversions can be sized against those brackets, moving money from traditional to Roth at a known cost now instead of an unknown one later.

The TSP also offers Roth contributions during employment, and whether to use traditional, Roth or a mix is a bet about your bracket now against your bracket later. For federal employees the answer is often less obvious than it looks, because the annuity itself provides substantial taxable income for life, which can keep a retired household in a higher bracket than it expects.

What constrains the conversion window

The state line point is specific to this metro and comes up constantly. It is covered alongside the rest of our tax-efficient retirement planning work, which is done with your CPA rather than instead of them.

Withdrawal order once income starts

The same spending funded from different accounts produces different tax results. Traditional balances are generally taxable when withdrawn, Roth balances generally are not, and taxable accounts have their own treatment.

Exhausting one account type before touching the next is the common default and rarely the best answer. Blending across types each year, with an eye on the thresholds in the table above, usually smooths taxable income across many years rather than minimising it in the current one. The mechanics of how that becomes a monthly paycheck are in how retirees turn savings into a monthly paycheck.

Three things that catch people

• Withholding defaults. The default withholding on an annuity or a TSP distribution may not match your actual rate. Underwithholding surfaces as a bill and possibly a penalty. Set it deliberately at the start.
• Early withdrawal timing. Rules differ between the TSP and an IRA, and an exception that applies in one may not follow the money to the other. Check before moving anything, not after.
• Conversions done late in life. A conversion is a taxable event in the year it happens. Doing one in a year that also contains a large payout or an unusual gain can cost more than it saves.

Federal households in Olathe

Olathe is the Johnson County seat and home to Mahaffie Stagecoach Stop and Farm, the last remaining stagecoach stop on the Santa Fe Trail preserved for the public. It is the furthest west of the Johnson County communities we work in regularly, about thirty minutes from the office. The tax conversation there looks the same as everywhere else in the county with one addition: a number of households are weighing whether to stay in Kansas or move across the line, and because the two states treat retirement income differently that question belongs in the projection rather than being settled afterwards. That modelling sits inside our federal employee retirement planning. See the communities we serve across the Kansas City area.

CFG Wealth Management Inc. is an independent firm based in Prairie Village, Kansas, led by LaMont Chandler, CRD 2794744. We are not affiliated with any other firm operating under a similar name. LaMont holds FINRA Series 7, 24 and NASAA Series 63, 65 registrations and has been registered in the securities industry since 1996. He is registered in Kansas, Missouri, Texas and Idaho. Securities and advisory services are offered through Madison Avenue Securities, LLC, member FINRA and SIPC, and a registered investment advisor. CFG Wealth Management Inc. and Madison Avenue Securities are not affiliated companies. His record is available on FINRA BrokerCheck.

Common questions

Where this connects

• Tax-efficient retirement planning
• Federal employee retirement planning: how the pieces fit together
• How FERS retirement works
• How retirees turn savings into a monthly paycheck
• More retirement planning insights