Federal workers who retire early and take the lump-sum pension payment option will be subject to an additional 10 percent tax on that money, according to new regulations about to be issued by the Internal Revenue Service.
IRS officials said yesterday that tax guidance rules will be published in the next few weeks in a special updated issue of its Comprehensive Tax Guide to U.S. Retirement Benefits, also known as Publication 721. That publication, and numerous other IRS tax guides, had to be revised because of the tax revision act.
Under legislation approved last year, federal retirees can elect to get a lump-sum payment equal to the amount of money they contributed to their pension fund while working. For most, that would be the equivalent of about 7 percent of their lifetime federal salary.
The tax revision act made a number of changes in the taxability of both private and federal pension benefits. For U.S. workers it eliminated the so-called three-year recovery rule. That rule allowed retirees to draw untaxed benefits until they had recovered all their previously taxed pension plan contributions. For the typical federal retiree that untaxed period generally lasted about 18 months. New rules require retirees to pay taxes immediately on the main portion of their annuity, which is based on the government contribution to their pension plan. The exact part of the taxable annuity is based on the estimated lifetime benefit of retirees and their actuarial life expectancy.
The tax overhaul act also imposed the same tax formula on lump-sum pension payments for U.S. retirees. In other words, retirees taking the lump sum, which would reduce their annuities by 8 to 12 percent, would have to pay taxes on a major part of that payment.
Now the IRS is working on guidelines to implement another change forced by tax revision that imposes an additional 10 percent tax liability on lump-sum payents taken by persons who retire early. For nonfederal workers, who typically have a higher normal retirement age, the cutoff is age 59 1/2. For federal workers, who generally cannot retire before age 55, the cutoff is age 55.
Generally speaking, government workers cannot retire before they are age 55 with 30 years of service. Employes may retire at age 50 after 20 years of service, or at any age after 25 years' service if their agencies offer early retirement because of reductions-in-force or if their jobs are abolished. Those are the people who would be hit with the new 10 percent penalty tax.
Under the rules, which still have not been supplied to the Office of Personnel Management or other federal agencies, retirees will be liable for the extra 10 percent tax on their lump-sum payments if they retire and elect the lump-sum payment prior to the year they turn 55. That penalty on lump-sum payments to private sector retirees would apply to anyone retiring prior to the year they reach 59 1/2. For instance:
A federal worker celebrates his or her 54th birthday anytime during 1987 and retires and elects to receive the lump-sum payment. That person would be subject to the additional 10 percent tax.
A federal worker retires this year and turns 55 sometime during the 1987 calendar year. That person would not be subject to the 10 percent added tax.
This change, unknown to most federal workers and retirees, will make the lump-sum option even less attractive for early retirees.