***This is an updated article. See Post Script at the bottom***

Today’s topic comes from one of my Facebook group followers.  I recently solicited my Golden Albatross group on subjects to research and write about, and Mr. Yankee responded with the following question:

Has there been discussion of how to shelter your pension benefits from federal tax? When I retire I expect to receive about $60,000 a year from my pension I’d hate to give a large portion of it back to the government.

I told Mr. Yankee I would look into it since I’d yet to conduct an in-depth analysis of pensions and taxes. It’s a bit premature considering the fact that U.S. tax law is undergoing its first major overhaul since the 1980s. Currently, the House and the Senate are working on reconciling their two different bills into one in order to approve and send to the President for signature. However, my research only shows one proposal in the House bill with the potential to impact this conversation in any meaningful way, and I believe I can address it appropriately. If something radical happens in the reconciliation process, I will simply update this article when the dust settles.

I am also going to assume that Mr. Yankee is asking for research into legal methods to shelter pension income from Uncle Sam, since other than listening to Judas Priest or watching Beavis and Butthead, we don’t promote “breakin’ the law, breakin’ the law” on this site. For my international readers from countries with simpler tax codes (and no Beavis and Butthead), it’s worth noting many U.S. citizens consider it their right to pay as little tax as legally allowable.

I don’t necessarily disagree with that line of thinking, nor do FI blogging mainstays like the Mad Fientist, but sometimes there can be a fine line between legal and allowable. That, in part, is why I use an accountant. Since I am not a tax professional by trade, I would urge anyone who reads this article to consider it a starting point for a discussion with their own accountant or professional tax preparer. As hard as I strive for 100% accuracy in all my articles, do not consider this the definitive word on taxes and pensions — even you Mr. Yankee!

Definitions and Biases

Before I get into my analysis, it’s also worth reminding everyone that my definition for a pension in this series is a Defined Benefit Plan (DBP) as defined at Investopedia. I know there are other types of pensions out there, or even tax-deferred retirement vehicles designed to look and act like a pension. However, for the roughly 15% – 20% of private sector American workers, and the 70% – 80% public sectors workers, still eligible for a pension, the DBP remains the standard.

My personal belief as a result of my research is if a person can accept the Worth vs. “Worth It” trade-off a pensionable career, then a pension can be a great tool for achieving FI. However, like all tools, it comes with pros and cons. The obvious pro is a pension offers a fixed income stream in retirement. The obvious con is that not all pension plans are well run. Therefore, not all pensions will be available in part, or whole, for all retirees when needed.

As a result of the pension safety issue, a lot of people in the FI community (and elsewhere) like to default to “I am just going to assume that the pension won’t be there, but if it is, it will be a nice extra” for their retirement planning. In most cases, that is not a realistic assumption. With just a little bit of research and pro-activity, a person can weave a pension into their retirement plan with a realistically accurate estimate of the likelihood that the pension will be there.

Finally, I try hard to keep this blog apolitical, but sometimes I can’t help it. My blog’s decidedly pro-pension outlook and theme constitutes a political stance these days. Fortunately, I don’t address political issues too much. However, the GOP’s proposed tax reform, and its potential impact on the future of pensions, makes it unavoidable in this article. If that turns you off, I’m sorry, but consider yourself forewarned that the second-to-last section of this article gets mildly political.

The Scenario

Mr. Yankee’s situation which prompted his question follows:

• He is a New York state employee
• He is looking at about $60K in pension annually from the state
• New York state doesn’t tax state pensions
• He is married and files taxes jointly
• His wife, Mrs. Doodle, will earn a pension of roughly $30K a year, also from the state
• No expected disability for either of them
• Mr. Yankee’s pension required a 3% contribution during his first 10 years of work
• His pension contributions technically fell under section 414(h) of U.S. tax code
• Mrs. Doodle contributed to her pension as well, her contributions were possibly 414(H) as well

Again, in Mr. Yankee’s own words:

So as far as I can tell we will receive roughly $90K annually which will be federally taxed as income. #1 I am super thankful for the blessing of the pensions. #2 I know that there are 14 states (including our home state of NY) that will not tax NY state pension income – (some of these states have no income tax at all). But I don’t know of any way to shelter that $90K from Federal tax.

The Short Answer

Mr. Yankee, the short answer to your question is that I’ve yet to find any major tax loophole or FI hack that legally shelters major portions of a pension from U.S. Federal tax. Needless to say, if someone had figured out how to shelter their pension from U.S. Federal tax, it would be all over the wiki-googles. It is not, or at least doesn’t appear within the first three search pages! Just kidding, I looked a lot harder than just the first three pages. However, I discovered a few interesting tax saving tidbits during my research that you may or may not be aware of. I wasn’t, so I share those with you below.

The Longer Answer

Again, Mr. Yankee, just to be clear, no major tax loophole that I could find at the Federal level, and you already identified the States that don’t tax a New York pension.  I’m sure the top 1% of the top 1% may be able to pay an accountant to find ways to transfer their pension offshore to avoid taxes, but that sounds highly illegal, and begs the question why they would have a pension anyway? In any case, other than Judas Priest and Beavis and Butthead, this site doesn’t promote “breakin’ the law” … yada yada yada.

However, I found several interesting tax tidbits about your situation that many readers might find interesting! First off, it turns out 414(h) of the U.S. tax code is all about the exciting world of Employer Pick Up Contributions. What are Employer Pick Up Contributions you might ask? I don’t know. They are treated as tax-deferred income just like a contribution to a traditional 401K or an IRA though. Thus, Mr. Yankee you were never taxed on those contributions to begin with. This means much like a traditional 401K or IRA, you have to pay the tax man once the pension payments start since you’ve yet to pay him for the money you earned. It’s the “pay now or pay later” principle, the same principle that governs the difference between Traditional and Roth retirement vehicles. In this case, due to the 414(h) provisions of your pension, you pay later.

In the end, what does that mean to you? I suspect probably not nearly as much as it meant to your employer, but I’ll let someone else research that idea if they are curious. At most, 414(h)  saved you from paying State tax on the 3% earnings you contributed (assuming you stay in a state that does not tax pensions). Outside of State tax relief, that automatic 3% deferment in conjunction with your other deductions may have kept you in a lower Federal tax bracket from time to time. However, unless you were using an accountant who really knew his or her stuff, that was probably completely coincidental.

Fun tax-fact number two is the opposite of the 414(h) effect. Let’s say for a moment Mrs. Doodle’s made post-tax 3% contributions to her pension. In that case, according to IRS Publication 575:

If you have a cost to recover from your pension or annuity plan, you can exclude part of each annuity payment from income as a recovery of your cost. This tax-free part of the payment is figured when your annuity starts and remains the same each year, even if the amount of the payment changes. The rest of each payment is taxable.

Think of it this way, the IRS taxed her “principle” (i.e. her pension contributions) already, but they didn’t tax her “interest.” In this case, the difference between how much her pension contributions totaled vs. how much she stands to earn from her pension, is the “interest”. Thus, upon commencement of her payouts, each payment will include a small part that is a “principle” repayment and a larger portion that is an “interest” payout. Those “principle” repayments are not taxed, but the “interest” payouts are. In case anyone is interested in the details, they can read more at the IRS Publication 575 and the IRS Publication 939 pages.

Now, Mr. Yankee, there are a few other issues worth considering. The reason I asked about disability is that certain types of disability payments are tax-free, but others are not. According to IRS Publication 575, “You may be entitled to a tax credit if you were permanently and totally disabled when you retired. For information on this credit, see Pub. 524.”.  IRS Publication 524 is Credit for the Elderly or the Disabled. I am not saying you should go out and throw yourself in front of a bus tomorrow, but should unfortunate luck befall you while on the job and leave you disabled, it’s worth a read. I’d be remiss if I didn’t mention disablement due to military and government service as well. IRS Publication 575 states the following:

You may be able to exclude from income amounts you receive as a pension, annuity, or similar allowance for personal injury or sickness resulting from active service in one of the following government services:

• The armed forces of any country
• The National Oceanic and Atmospheric Administration (NOAA)
• The Public Health Service
• The Foreign Service (State Department)

The last category of special tax treatment due to disability would be for those unique survivors who may have suffered disability from a terrorist attack.  I can only suppose that was a post 9/11 addition to the tax code.

Mr. Yankee, are you retiring a first responder perchance? They receive certain privileges under the tax code as well. Once again as detailed in IRS Publication 575:

If you are an eligible retired public safety officer (law enforcement officer, firefighter, chaplain, or member of a rescue squad or ambulance crew), you can elect to exclude from income distributions made from your eligible retirement plan that are used to pay the premiums for accident or health insurance or long-term care insurance.

The IRS’s list of qualified plans includes qualified trust (typically pension trusts), a section 403(a) plan, a section 403(b) annuity, or a section 457(b) plan. That sounds like a fairly sweet deal to me, especially given how much people are planning to pay for health care these days. Again, I’d be remiss if I did not mention that the U.S. military has something similar, but instead of healthcare insurance, it is associated with Survivorship payments. I touched on that perk in my Survivorship article for the Pension Series if you want to know more.

The GOP’s Answer: Tax the Money at the Source

Finally, and only tangentially related to your question, I feel it’s important to note that the current GOP tax reform effort contains a clause in the House version of the bill that could impact many, if not most, public pension funds negatively. Actually, that may be the tax-related understatement of the year. Through the expansion of obscure rules dealing with unrelated business income tax (UBIT), the House version of the tax reform bill would tax heretofore un-taxed investment profits of public pension funds. That means any State level and below pension fund may find itself paying a new annual tax bill. A KPMG study of the House tax reform proposal notes:

If adopted, this provision could have a significant impact on public pension plans and on the funds in which they invest their assets.

Maybe you don’t trust a study by one of the big four accounting firms partly responsible for the Great Recession. Fair enough. How about a quote from a staunchly Republican politician from a staunchly Republican state? As Utah’s GOP state treasurer noted:

Repeal of the exemption (as was proposed in the House plan) would significantly reduce investment earnings generated by Utah Retirement Systems. Such reductions would have to be replaced by additional contributions from state and local government employers that participate in URS, ultimately burdening Utah taxpayers with added costs.

Now Mr. Yankee, I can’t find any news articles directly citing the impact to the New York State employee’s pension fund, but I don’t think its a huge leap of logic to assume your pension fund will feel a negative impact as well. As someone who advocates for the utility of pensions in achieving FI, I would highly advise anyone who has a public pension coming their way (at the State level and below) to research the UBIT issue to see how it might impact the stability of their pension fund.

A Grumpus Maximus Tax Retort

OK, now for the politics, so for those of you uninterested, you skip to the conclusion now … For those of you that stayed, if and when you determine the impact of the UBIT proposal on your pension fund; I would urge you to call your Representative and Senators’ offices and lobby them to drop it from the reconciled version of the GOP Tax bill.

Here is my reasoning. The KPMG report I cited above states this provision only stands to raise $1.1 billion in tax revenue over ten years. Latest non-partisan analysis from the Congressional Budget Office (CBO) estimates the GOP tax reform effort would increase the Federal deficit by $1.4 TRILLION in the next 10 years. That $1.1 billion raised is a drop in the bucket compared to the $1.4 trillion cost of this tax bill. Mathematically it barely dents the overall negative impact to the Federal budget that this proposed tax plan creates. In fact, it broke my computer’s calculator when I tried to figure out what percent 1.1 billion is of 1.4 trillion.  I got a number that looked like this: 7.857142857142857e-4

I don’t even know what that means, but I bet it is small!

On the flip side of the coin, I believe it’s also important to note that analysis from both the CBO and the Joint Committee on Taxation (JCT), shows the proposed tax reform favors the rich, specifically those who make over $500K a year. It should also come as no surprise that the entire point of the Tax reform effort is to cut the business tax from 35% to 20%. While I understand that impacts small business owners as well as large corporations, the reform proposals draw no difference between your locally incorporated hardware store and Apple with its roughly $200 billion in yet to be taxed cash reserves sitting off-shore.

Let me just sum this issue up:

• The House version of GOP Tax Reform Bill proposes to raise roughly $1.1 billion over the next 10 years by placing UBIT provisions on public pension funds
  • Many of these pensions funds are underfunded and stressed, to begin with; as I’ve noted elsewhere on this blog

While in the meantime …

• Both House and Senate versions of the Tax reform plan will raise the U.S. Federal Deficit by $1.4 trillion over the next 10 years
  • Which non-partisan budget analysis shows will primarily benefit those who make over $500K annually
  • And give large corporations a huge tax cut

In the immortal words of Homer Simpson, “Frustration… BUILDING!”.

I Wish I had Better News

Well, Mr. Yankee, I wish I had better news for you, but I think you’re going to be stuck paying Federal tax on the majority of your pension earnings. I know we instant messaged with each other, and you expressed a fear of paying 25% to the U.S. Government. My simple response to your fear about paying 25% Federal tax on $90K in pension money, is to say you won’t! The progressive Federal tax system in the U.S. means you are only paying 25% for the money that spills over from the 15% tax bracket. Although I’ve yet to examine the new brackets proposed by the House or Senate if you and your wife were making $90K from pensions today but taking the standard deduction for married filing jointly, you would only be paying 25% on about $1700. That’s before any other tax considerations like the ones I mentioned above.

Thus, despite my nearly 10 days’ worth of research and writing on this subject, I think the best thing I could share with you is the philosophy of one of my all-time favorite early retiree bloggers. I’ve mentioned Darrow Kirkpatrick several times on my blog, and have even written a guest post on his site Can I Retire Yet?. He has a philosophy about taxes in retirement that I think suits your case perfectly:

My philosophy is to keep my financial life simple, live frugally at low tax rates, and then pay my share without squabbling. The complexity and conniving that our tax code seems to invite, always feels like a colossal waste of time to me.

Now that may not suit everyone, but in your case, you’ve already identified the best thing you could do to minimize taxes in retirement, and that’s to live in a state that doesn’t tax pensions. Turns out you didn’t need my help after all! If I were you, I wouldn’t worry too much about your Federal tax situation. It’s going to be what it will be.

If anything, I think it would be a far more productive use of your time to examine the impacts of the House’s UBIT provision in the Tax reform bill on your pension. The good news is that even if the UBIT expansion passes into law as a part of the overall reform effort, it will almost certainly be challenged in court. Thus, you’ve got time to roll up your sleeves and formulate a plan, if and/or when it passes the reconciliation process and is signed into law.

With that said, I have one more obscure topic that touches upon your question, but I am going to save it for my next article in the Pension Series about Geoarbitrage and Pensions. Until then, thanks for the question. I hope you and all three of my non-related readers found it useful!

Post Script – 20-DEC17 – I am happy to report that the UBIT proposal was removed in the final House version of the Tax Reform and Jobs Act bill that passed today. Thus, whatever other flaws the bill may have, it will not have a provision that negatively impacts public pension funds. All that writing and worrying about nothing! I will keep my eye on the issue to ensure congress does not try to sneak it through elsewhere.