#127 Avoiding Tax Traps: What Every Federal Employee Should Know

Micah Shilanski 00:00
Welcome to the Plan Your Federal Retirement podcast. I’m your host, MicahShilanski, and today, we’re going to be going over a lot of questions that we’ve been getting as people prepare to retire, and it comes this really big thing that we talk about all of the time, but we’re going to go a little bit more into details, you know, we’re going to talk about our favorite aunt that’s right, the IRS Aunt IRS, and, you know, a little bit of things on how they’re taxable as we get into retirement, and to bring this all home, I wanted to bring my dad back on the podcast Floyd Shilanski, because he has a wealth of information over 40 years of tax knowledge up in that brain, and so we can really kind of dive into a little bit more in the experienc, so pops, welcome to the pod.

Floyd Shilanski 00:37
I appreciate being here again today. It’s a beautiful day out there in the neighborhood, and I love to talk about taxes and debunk some things that we take for granted. You know that great quote I’m going to attribute to Eleanor Roosevelt, and that’s not what we think we know, is what we think we know, that just ain’t so and so many times that comes out when we talk to our clients and people on the podcast about federal income taxes while we’re working, and all my when we get ready to retire.

Micah Shilanski 01:05
Yeah, so important, you know, this is slightly off topic, pops, but with, like, all of the stuff going on with, you know, the the VERA, the early outs, all these things, I’ve been really working with, a lot of clients, been like, hey, you got to get that certified summary of federal service, this is super, super important, and I had a newer client, and she’s like, no, Micah, I know my service, I know my service, you know, I’m going to have 26 years by the end of this year, I’m going to be able to do the deferred retirement, and so everything sound really great. I was like, Hey, you really got to get the certified summary federal service, she’s like, no, no, I got it. Long story short, she applied for the deferred retirement, and she’s out of the east coast, but she applied for the deferred retirement, they’re like, oops, you don’t have 26 years until the beginning of next year, and she’s not eligible for that deferred retirement that she was planning on. So back to what you you were saying, pops, it’s not what you don’t know, that’s the issue, it’s what you think you know that just ain’t so, and we can be really caught in in in our they’re stuck in our ways, right, about saying, no, this is it, I know this for a fact, I know this is my service, I know this is how tax is going to be, I know what my cash flow is going to be, and we’re here to tell you on the other side of this, we see a lot of mistakes with those things. So you know it’s it’s walk with us down this path, if you don’t mind, for just a little bit and just, just for fun, just say, hey, what if what you thought you know about something wasn’t actually the way it is, what would you wish you had known about that? And when would you had wished you had known about this? I don’t dismiss this pod so quickly as you’re going through it, because one of the things that I love about this is we like to be really transparent as confidentially as we can, but with issues that we see from the federal employees that are retiring, right? And we want to share those with you so you can avoid these mistakes in planning your retirement.

Floyd Shilanski 02:44
You know, Micah, that just brings up the thought, you know, we do these in live programs and people, so you you guys, you’re just making up these stories, and we don’t have to make them up. We live on every day with the people that we represent or we talk to, and the federal government getting ready or trying to get ready to retire.

Micah Shilanski 03:01
You know, pops, is what I love to say, I love working with federal employees. I don’t got to make anything up. You guys do it, right?

Floyd Shilanski 03:05
We just changed the names to protect the innocent. That’s right.

Micah Shilanski 03:09
That’s right, we have tons of stories. So let’s get into one of the things that bites, and we talk about taxes a lot, oh, pops, I’m gonna pick on you, actually, since we’re live. If one of the things that I always thought was like a normal right growing up, is seeing my dad, you know, build the financial planning firm working with clients, is he clients, is he’d always be reading taxes, and so when I got into the business, I always started reading about taxes too, and like, actually reading the tax act, reading the codes, etc, not not the filter points that we get from the little bits and clips of the news and media, but actually reading the documents. And I thought this was normal behavior, and then as I talked to other advisors all the way across the way across the country, they’re like, what do you mean you read the tax code? And I’m like, well, it’s like, the rules that govern the taxes that our clients pay, and, like, I read them, and it was this blew me away, that so many other people do not do this, and I think it’s really important that things that are such a massive impact, I mean, tax is gonna be the largest bill you’re probably going to have in retirement, something that’s that large of an impact, we should understand how it works, or work with somebody who understands how it works. So anyways, pick on you, or just say thank you for instilling that in me. I really do appreciate it. And who doesn’t reading tax law.

Floyd Shilanski 04:16
I remember on there were books, and we would have the books, and now it’s all digital, right, yeah, yeah.

Micah Shilanski 04:21
All right, so let’s dive into this a little bit pops. One of the things is, we go through this, we need to be talking about what pensions are taxable, what pensions are not taxable? How does that work? So there’s a variety of different income sources that people are going to have coming in, and I’m going to call these are fixed income sources, and for the purpose of today’s pod, we’re defining fixed income as an income source you cannot control the amount. For example, Social Security pension, military retirement, other pensions, etc. So you work so long it’s X dollars, you turn it on. So we’re going to be talking about these fixed income. Pops I think we have five or six listed here. Let’s tackle them one at a time. Let’s kick off with so. Social Security. Is Social Security taxed in retirement or not?

Floyd Shilanski 05:04
You know, great question. Micah, if you can live below the poverty line, your Social Security is probably going to be income tax free. However, it’s going to be taxable at some state, and then when you retire and relocate to other states, it’s, does that state tax that social security becomes a question. You know, the big thing and the surprise that I see so many times, Floyd I turned on my Social Security, that’s great, did you have taxes witheld? And I get this blank look on your face, no, and then just recently, you know, how many of the people that we reviewed their taxes found out in the call and they said, hey, Floyd, wait a minute. How come my Social Security is taxed? I said, well, it you tax it going in, and regrettably, you’re going to tax it coming out. Now it’s staged. It’s not all at one 85% unless you exceed an income level, and then it’s like, oh my God, now I got to write a check to the IRS, and typically it’s multiple thousands of dollars. So I, as I have worked with my clients, or we work with people that you know they’ll call in for their appointment. I say, look, when you file for Social Security, you’re going to get a check, fine. After you get the first or second check, talk to your advisor, talk to us, and then you need to file a W-4v, voluntary to start having taxes withheld, because if not, you’re going to probably end up writing a check come April 15, because we hadn’t planned for this extra 30 or $40,000 of Social Security being income taxable to you.

Micah Shilanski 06:27
Yeah, this is really important, right? And I’m just looking at my handy dandy tax guide that we always keep on on our desk going through this. There’s seven or eight states that also tax your Social Security in addition to the federal, so pops, what you’re saying if you have a married filing, joint your incomes exceeds your adjusted gross income, roughly $44,000 a year, right from all other sources, pensions, IRA distributions, TSP distributions, working, etc, up to 85% of your Social Security is subject to tax. Now it’s not an 85% tax rate, they take 85% of your Social Security, and that is taxed at your marginal tax rate. And this is what really throws people off, because by default, when you apply for Social Security, they do not allow you to withhold taxes when you apply for it. So this becomes a bit of a pain in the toshi, or at least for us, right? Because we’re always telling our clients, hey, let’s make sure we have taxes withheld. You cannot do it when you apply. You have to do it after that income starts. You have to fill out a W-4v, either fax or mail it to your Social Security office, and then you can have taxes with help. And it’s really important to do that, especially you Turbo Tax guys out there, so if you do Turbo Tax, this is one of my gripes on Turbo Tax, it’s a great program, does a lot of good things, right? But, but this is one of the my gripes on it. It does come back and it tells you what your effective tax rate is. Your Social Security is not taxed at your effective tax rate. Your Social Security is taxed at your marginal tax rate because it’s new income that’s coming in. So what’s your effective tax rate? Effective Tax Rate is they take your total taxes, I’m sorry, I’m geeking out here, geek moment, we’ll come, will end in just a minute. They take your total tax liability, total taxes that you’ve paid throughout the year or you owed, and you they divide that by your income. So it comes out with a smaller number. Your marginal rate says, hey, any new money you have coming in, what rate is that going to be taxed at? So if your effective rate is 9% but your marginal rate is 22 and you don’t withhold 22% taxes on your Social Security, you’re gonna end up with a big tax bill at the end of the year. So be mindful of that when we talk about our Social Security. All right, next one kind of have on the list, pops on is FERS, your Federal Employee Retirement System pension that you have coming in, and just as you had said, dad, with Social Security, this is also subject to tax when it comes out, there is a little bit of this benefit which is going to be tax free, and that’s going to be the return of your contribution. Now most people into FERS, that not FERS Rae or FERS Frae, but most people in traditional FERS paid, in point, 8% of their pay a very small dollar amount. So you’re going to be getting that very small dollar amount back throughout your life tax free, but virtually 99% of your pension is taxable. Pops, did you say that’s about right,

Floyd Shilanski 09:11
100% But how many times that we see people that say we’ve already paid taxes on it? Now that’s a small percentage of the FEDS. I mean the 2 or 3% and all but I’m always rocked on my heels when someone says, well, Floyd, I’m getting this pension, I’ve already paid taxes on it, I go explain that to me, and they go through this elaborate explanation, because they read this thing on the Facebook, or they read this someplace out there on Twitter, and they said, well, I fall in this category. I go, real interesting, tell me more, because all my FEDS pay taxes on their income, and then let you know some of the military guys that we have some VA benefits, then we get some of that that’s income tax free. So I think sometimes there’s a confusion on where that checks coming from.

Micah Shilanski 09:53
Yeah, very, very much, so speaking of where the checks coming from, oh, that’s one of the things on their withholding. I’m sorry, the FERS benefit. Again, OPM, by default, does not withhold enough taxes, so you definitely have to increase that a little bit more, and one of the reasons not picking on OPM, they don’t know what other sources of income you have coming in. So the only thing they know is they say, hey, you’re married, you have a pension of 30,000 bucks a year. Well, hey, married and $30,000 a year, you pay pretty much zero in taxes, and they have pretty much zero with help, but they don’t realize it’s 30,000 from your FERS benefit, 30,000 from a Social Security your wife has a pension income plus a tsp distribution, you have 150,000 income. You’re no longer in a 0% tax bracket. So it’s all of those things that add up. And then we have the double dippers, right? The military retirees, which is great. So you work for the uniformed service for 20 years, you get out with a pension, then you go work for civilian service and coming in, and you get that military pension coming in, pops, how is that military pension going to be taxed? Your retirement should be the most exciting next chapter of your life, but that doesn’t happen by accident, that happens with you taking the careful time consideration and planning to make sure you get all of your retirement and I gotta say, that’s one of the things I love about my job, is being able to sit down with federal employees, we want to look out in the future with them, find out what that ideal life is going to look like, and then how do we plan for that today? What are the tweaks we need to make in your life to make sure you’re getting the most out of your benefits, whether it’s understanding your federal pension and making sure you get paid for all the years you’re supposed to when do we turn on Social Security, 62, FRA, 70 and change? How do RMDs affect our taxes? What’s the best way to maximize our TSP so we never outlive our money, but enjoy a great lifestyle along the way? These are just but a handful of the questions that you need to make sure you’re answering as you’re preparing for your retirement, our team specializes in helping one on one, federal employees achieve their retirement goals and answering those questions and so much more. So if you’ve ever wondered what the answers those questions are, then now is the time to make your appointment to meet with one of our specialists today. The best way to do that is go to planyourfederalretirement.com/call, that’s planyourfederalretirement.com backslash call, and you can book your consultation to sit down with one of our specialists in your federal employed benefits and financial planning to make sure you’re getting the most out of your benefits. This is the time that you have to make sure you’re dotting the I’s and crossing the t’s to get all of the money that you’ve earned for your retirement. So take that action today. Sit down with someone that understands what you need, what you want, and can help you achieve those goals. Until then Happy Planning!

Floyd Shilanski 12:39
You know, it’s just like the FERS, unfortunately, the pension itself is going to be 100% income taxable. And then you start combining it with all the other things that come in, and you find yourself in a, you know, in a 28 or even a 32% tax bracket. You know, one of the things that I used to say, I’d love to get everyone to be income tax free. But you start looking at, you know, you combine military retirement plus a FERS retirement, and all of a sudden, in retirement, they’re making the exact net income while they were working. And I think that’s a great plan, that they can live exactly the same way and not have to worry about dipping or pulling from the different investment programs. So yeah, I think that that would be phenomenal tax planning Micah.

Micah Shilanski 13:24
Yeah, all right, another source of income for military recipients is also going to be VA disability pay. Yeah, great news, this is 100% tax free as disability pay when it comes in. Now, with that disability pay, there’s really not a survivor benefit associated with that. So that income does go away when you pass away, but it’s a great benefit that comes in, tax free, federal and state, and then, oh, sorry, pops, go ahead.

Floyd Shilanski 13:48
No, I was just going to say, you know, on that so many, so many times, I work a lot with the military and surviving spouses, as you know, when their death occurs, they’ve already got factored in, they’re going to get 50% or a piece of that VA benefits, and it’s kind of a shock to say, you know, I regret to tell you this goes away upon, you know, some your spouse’s debt.

Micah Shilanski 14:10
This is so important to do what we call a survivor benefits analysis, to really look at and basically it’s cash flow, right? Our thought on life insurance is pretty simple, it’s just math, you need it or you don’t, and it’s as complicated as that. And so it’s, we don’t really look at it as an investment vehicle these other things. It’s more of just replacing an income. So, you know, God forbid, if you were to pass away, what income is your spouse going to have? And do they have enough to make sure their standard of life is taken care of? If the answer is yes, then awesome. You don’t need life insurance. If the answer is no, then you need life insurance, and this really comes in with the disability pay as well, because when that turns into a pumpkin and goes away as probably a substantial amount, could be a substantial amount of income that your household is living on that you no longer have, so we really got to look on these other sides and say, hey, are you okay? Is everything balanced on the site?

Floyd Shilanski 14:59
Yeah, without a doubt now, Micah, you know, and then just think about it, you got Social Security, you got FERS, maybe a military pension, VA benefits, you went to work for a state program, and you’re, you know, you’ve got another retirement coming in, and maybe you got rental property, and you got that passive income flowing to you. All of a sudden, there is complications with that, especially when I’m retired, I’m no longer working, but you still got the same tax bill, and then people get drift, you know, I call it sucked into the web, because they read all these articles how to avoid long term capital gains, how to avoid this, how to avoid that, and regrettably, taxes are there, and if you don’t plan for them adequately, you’re going to be dipping into those saving pots to pull money out to pay the taxes are the difference of withholdings.

Micah Shilanski 15:45
Yeah, and I always like to say, when people are getting ready to retire, they’re like, how do I handle my tax bill? How do I handle my cash flow? How do I handle my distributions? I’m like, Hey, you worked pretty successfully for 40 years between all these different jobs. How did you do it for the last 40 years? Let’s plan on doing that for the next 40 years. So if you’re used to withholdings and having all your taxes withheld so you don’t have a big surprise in the year, then do that right? And that’s where most people should fit into that category, have it, are there things that will throw us off?Absolutely! Last year was a huge year for capital gains, and so there was a throw off on offer a lot of our clients is, you know, they had a little bit more tax folks at the very end of the year, they had these big capital gains, which is a great things to have, but we got to pay taxes on them. So there could be those little things from time to time, but it’s definitely something that you should be looking at. And also every time they change the tax code. Now, I know this is coming out kind of mid year, but they’re probably going to change the tax code here soon, and when that comes out, they often mess up withholdings a lot of times kind of the circular E is updated, software is updated, etc, and it doesn’t do the withholding. So anytime you’re any of these pensions change, and all of a sudden, you’re getting more money magically. It’s really worth looking at and saying, hey, are my tax withholdings going to be accurate for the way that that everything is set up for it. I know pops years ago, there was a payroll tax benefit that was kicked out to a ton of people I’m trying to remember it was in the Obama administration, they had kind of kicked this out. Was an extra credit that was there, but most of our clients did not qualify for it because their income was, quote, too high, and too high was like 100 grand a year, married filing joint, and so they owed that money back at the end of the year. So it’s kind of this short term, you know, payroll loan that they were going to own back, and a lot of people just didn’t like the way that sat with them, because, you know, they got this money that all sudden have this big tax bill into the year, so anytime money comes in unexpectedly, your net changes unexpectedly, man, hit that pause button and say, what’s going on with that, and to make sure we’re having adequate taxes witheld.

Floyd Shilanski 17:44
You know, Micah, that’s one of the things that you and I talked to about pre podcast, was talking about a cash flow analysis, you know, and lots of difference between a tax preparer, all right, and someone that projects future revenue to the future. And I’m not going to pick on tax preparers, you know, I use a CPA. I even use TurboTax to kind of get ready, good or bad, but the reality is, they’re historians. We take all the information that we get them, and they look backwards and say, okay, based on the information you gave me, you owe this income tax now, you know, and the projection should be, let’s look at to the future and do a cash flow. So many of my clients, they would rather get $1,000 refund instead of write $1,000 check. So we got to do that balance, you know. And then we say, well, you know, here’s what, here’s the way we get around this big tax bill, let’s make quarterly payments. You know, in 5, 6, 7, years ago, the penalty for not paying on time was minuscule, right? All of a sudden, what was it, I think, mid year in Mr. Biden’s administration, that penalty jumped back up to what it was like pre COVID, and all of a sudden, if you don’t pay on time, uncle Sam wants extra money in this penalty, that’s a non deductible side of the equation. So now we’re adjusting W-4’s again to have a little bit more money with hell. So we kind of break even. And I don’t know about you, Micah, but I tell all my clients, plus or minus $1,000 I’m pretty happy if we got our taxes projected that way. But the other point of it is I want to go back to Social Security and understanding taxes. and like with Turbo Tax recently, we had a client that I always look at tax returns, so we’re going through this, and he’s got this condo, and we’re reviewing it, and I get down into his depreciation schedule, and he didn’t appreciate it or depreciate it, so I had to inform him that, hey, you know whether you do it year by year that you own this piece of property, you’re going to have to do it later on this recapture thing. So now we’re going through the thrills of modifying those tax returns to get the depreciation scheduled in. But same client, we were able to take his social security made 100 like about 120 married filing jointly, and you calculate Social Security, that’s an 85,000 or 85% tax rate, but we found a deduction from a capital loss he hadn’t taken. So we were able to go back to the tax preparer TurboTax, put in this loss that he had not taken, and it dropped him down from an 85% taxable range on Social Security to 50% so understanding tax laws, understanding how they affect, especially like Social Security, just really important, and TurboTax didn’t catch that unfortunately.

Micah Shilanski 20:22
It’s one of those aspects G, I – G, O, right? Good, in, good out, garbage in, garbage out. You know, any software that’s out there is limited based on the information that it has coming in, so having somebody else check your stuff, I’m a huge proponent of that one as well, which is why we love to look at our clients tax returns and have a have a once over with them before their file then pop should bring up a really good point, and this kind of falls into our tax trap category. One of the things that our clients don’t expect and always like to help my clients with this, every single year we’re kind of reviewing taxes, look at this, but rental properties and depreciation and recapture, this gets super confusing, so I’m gonna see if I can put it in a one liner for everyone to understand, depreciation is a loan from the IRS, that means you have to pay it back. Now, it doesn’t matter if you want the loan or not, you’re getting the loan. This is the way it’s going to work, right? But depreciation is where you’re quote, depreciating a property over time is they’re loaning you a tax deduction that in the future, when you dispose of that property, when you sell it, you have to repay 100% of that loan at whatever tax rate it’s going to be in the future, you don’t get to control that. So this isn’t a good or bad thing, this is the way it works, right? And so you really got to understand that, because depreciation is one of those things that we forget about when we’re owning a rental property, we own it for 20 years, like, oh my gosh, look at all this appreciation, look at this equity, I could sell it, I’d have all this money, but we’re not thinking about aunt IRS, and what our tax bill is going to be with that federal and state, right? We have a lot of clients that have properties in Hawaii, and they look at selling them, and that’s a lot of revenue that the state of Hawaii is going to get when they sell those properties, so the client’s net at the end of the day isn’t as much as they’re originally thinking about. This isn’t good, this isn’t bad, this is just how it works, and that’s why, reason we’re on this podcast, right? We want to make sure that our listeners know how these things work, so you are not surprised about at the end of the day. So an action item, I would say, if you have a rental property, go find out what your IRS loan balance is. Now they don’t call it a loan balance, you go to a CPA, they may not be familiar with that terminology, but it’s what’s your accumulated depreciation on that that you’re going to have to repay. Now, you were paid at a tax rate, right? You don’t have to repay 100% of that depreciation, but it’s going to be at a certain tax rate in the future, and then keep that on your balance sheet when you’re ever thinking about disposing that property, about, hey, what’s that tax bill for selling it? Because the IRS is going to get paid first.

Floyd Shilanski 22:46
You know, Micah once, just to kind of plus that just a little bit on a lot of my business owners early on, and you know, when back in the 70s and 80s, we had depreciation savings accounts. So you have $100,000 depreciation, you’re in a tent, I’m just simplifying, you have a 10% tax bracket, so you just save $10,000 in taxes. Put that $10,000 away, because ultimately, when you sell that property, sell that piece of equipment, you have to recapture it, and just to add one more burden to it, if you’re on Medicare, or you’re over the age of 65 and you’re paying for Medicare now Part A,I mean, Part B, and all of a sudden you sell this property because I need this extra income in retirement. They got this thing called IRMAA that they’re going to go back two years and surprise, your Medicare payment will jump up from $150, 150 a month, to 500 a month, based on how that adjusted your income that year. So again, tax planning that is especially as we get closer to retirement, is just so very, very, very important for everybody.

Micah Shilanski 23:47
And pops that kind of goes through, you know, our goal of the podcast is we want to help another 1 million federal employees with retirement. The only way we could do that is listeners, with your help. I know taxes is only fun for Floyd and I to talk about because we really kind of geek out in this, so thank you for your patience as we go through it, but you can see that all of these different sources of income, and we didn’t even talk about your TSP, your IRAs, your capital gains, right? All we’re focused on in this episode was just those fixed income sources of just a couple of pension things, and what the magnitude of taxes that can be. Now the greatness is there’s a lot you can do about your taxes. If you’re looking through not being a historian, right? Looking backwards see what happened. But if you’re looking through the windshield of your life, right, looking through that and seeing what’s coming, especially with a big tax law change that’s going to be upon us this year and next year, depending on when Congress doesn’t, there’s a lot of things going to be updated. So make sure your stay tuned for this podcast and other great ones to get more information about your benefits.

Floyd Shilanski 24:39
Micah the only thing I would say, you know, the next phase of that is, you know, if you’re working with a CPA or you’re working with a tax preparer, go sit down, not well now, because it’s after April 15, and say, hey, look, let’s look at my 10-40 and let’s, what can we adjust? You know, what did I miss? What could I do differently? I want to project out the future. Well, you know, your W-2 is the same, it’ll be the same, maybe, but let’s sit and talk about doing a cash flow and analysis, and especially pre retirees. I can’t tell you how many times, especially, and in fact, in about 30 minutes, I’m sitting with the pre retiree, and we’re doing a cash flow needs, because Micah and I don’t want you to retire and have to live below the income that you’re living today. So what do we need to get there? How do we adjust things a year or two years before you retire, calculating what we think Social Security is going back to what your first pension is going to be, going back to what you may take out of the TSP, and just do it a net, not a gross, a net cash flow analysis. I think that would be very important thing, a nice action thing for them to do Micah.

Micah Shilanski 25:41
Great! Well, pops, as always, thanks for being on the podcast, to our listeners until next time Happy Planning!

Floyd Shilanski 25:46
Happy Planning!