Federal employees who leave federal service before they are eligible to retire can apply for a refund of their CSRS or FERS retirement contributions. This column discusses the federal income tax consequences of the lump-sum distribution of CSRS and FERS retirement contributions.
It is important first to discuss how much CSRS and FERS employees contribute each pay period via payroll deduction to their respective retirement systems.
The amount federal employees contribute to their Retirement and Disability Funds
Each pay period:
1. CSRS employees have 7 per cent of their after-taxed wages deducted and contributed to the CSRS Retirement and Disability Fund.
2. CSRS Offset employees have 0.8 per cent of their after-taxed wages deducted and contributed to the CSRS Retirement and Disability Fund.
3. FERS employees hired prior to January 1,2013 have 0.8 per cent of their after-taxed wages deducted and contributed to the FERS Retirement and Disability Fund.
4. FERS employees hired during the year 2013 have 3.1 per cent of their after-taxed wages deducted and contributed to the FERS Retirement and Disability Fund.
5. FERS employees hired into federal service after December 31,2013 have 4.4. percent of their after-taxed wages deducted and contributed to the FERS Retirement and Disability Fund.
Note: Federal employees who are in certain job classifications (such as Special Provision Employees and Congressional employees have additional amounts withheld from their salary and contributed to the CSRS Retirement and Disability Fund and the FERS Retirement and Disability Fund.
What is the purpose of employee contributions to their Retirement and Disability Fund?
When a CSRS or CSRS Offset employee contributes to the CSRS Retirement and Disability Fund, the employee establishes CSRS service time for the purpose of retirement eligibility. The same is true when a FERS employee contributes to the FERS Retirement and Disability Fund, the employee establishes FERS service time for the purpose of retirement eligibility. The contribution to the retirement and disability fund also establishes service time for the purpose of calculating the CSRS and FERS annuities.
What happens when a CSRS or FERS employee leaves federal service before retiring?
A CSRS or FERS employee who leaves federal service before meeting the requirements to retire under the immediate (voluntary) retirement rules can request a refund of their cumulative contributions to the CSRS or FERS retirement and disability funds. The following example illustrates:
Jack, aged 43, entered federal service at the age of 32. He has contributed to the FERS Retirement Disability Fund for 11 years. He also made a deposit for his three years of active-duty military service (more to follow). If Jack were to leave federal service, he can request a refund of all of his FERS retirement contributions and his military deposit.
Lump-Sum Credit
A lump-sum credit is defined as the “unrefunded amount of an employee’s contributions” to the CSRS Retirement and Disability Fund for CSRS and CSRS Offset employees, or to the FERS Retirement and Disability Fund (FERS employees) for FERS employees. The lump-sum credit consists of:
• Retirement contributions deducted bi-weekly from after-taxed wages. See above for the deduction amount percentages for both CSRS and FERS employees.
• Deposits for post-1956 military service.
• Deposits for temporary (“non-deduction”) service.
• Redeposits of CSRS or FERS contributions, and
• Interest paid on deposits made for post-1956 military service, deposits for temporary service, and redeposits.
In the example above, Jack had deducted from his after-taxed wages a total of $10,560 that was deposited into the FERS Retirement and Disability Fund. His military deposit for three years of post-1956 active-duty military service was $5,600, including interest. Jack’s lump-sum credit is therefore equal to $10,560 plus $5,600, or $16,160.
Payment of Lump-Sum Credit
An employee who chooses to leave federal service before being eligible to retire from federal service has the option of requesting a refund of the lump-sum credit under either the CSRS or FERS retirement system. The payment of a refund of the lump sum credit voids any retirement rights based on the period of CSRS or FERS service that the refund covers. Among the consequences of the refund of the lump-sum credit:
• A departing employee is not eligible for “deferred retirement” in which the employee would receive his or her CSRS or FERS annuity at a later date. A recent MFR column, FERS Deferred Retirement (https://www.myfederalretirement.com/fers-deferred-retirement-option/) discusses deferred retirement.
• A departed employee who decides to return to federal service in order to work the required number of years to be able to voluntarily retire with an unreduced CSRS or FERS annuity, and keep insurance benefits (FEHB, FEDVIP and FEGLI) in retirement, must redeposit the refund lump-sum credit (with interest) in order to have the period of CSRS or FERS service included in the computation of the CSRS or FERS annuities.
Application for Refund of Lump-Sum Credit
An applicant for a refund of the lump-sum credit must complete the following forms and send them to OPM:
• CSRS or CSRS Offset employees must complete Standard Form (SF) 2802 (Application for Refund of Retirement Contributions) and SF 2802A (Current/Former Spouse’s Notification of Application for Refund of Retirement Deductions) when required; and
• FERS employees must complete SF 3106 (Application for Refund of Retirement Deductions) and SF 3106A (Current/Former Spouse’s Notification of Application for Refund of Retirement Deductions) when required.
A portion of SF 2802 is presented here:
A portion of SF 3106 is presented here:
It is important that applicants use the correct application form. If a FERS employee requesting a refund of the lump-sum credit uses Form SF 2802 instead of Form SF 3106, it will delay payment of the refund. An employee must use the correct application to confirm that he or she is making an informed decision to apply for the refund.
Interest payable
No interest is paid on the refund of CSRS or FERS contributions: (1) If the service covered by the contribution totals one year or less; or (2) Is for a fractional part of a month.
Interest on refunded CSRS and FERS contributions is compounded annually through the last day of the month preceding the date OPM makes payment. The interest rate is determined annually, based on the average yield of new investments purchased by the Fund during the previous year.
Taxation of refund of lump-sum credit
The refund of the lump-sum credit is not taxable to an applicant. It makes no difference whether the applicant was a CSRS, CSRS Offset or a FERS employee because the lump-sum credit is composed entirely of after-taxed dollars. An employee’s bi-weekly contribution to either the CSRS or the FERS Retirement and Disability Funds were made with after-taxed dollars. Deposits for temporary time and deposits for active-duty military service were made with after-taxed dollars, including any interest paid.
The only taxable portion of a refund of lump-sum credit is the interest paid. The Office of Personnel Management (OPM), who issues a Form 1099-R to the refund applicant, will indicate on the Form 1099-R the lump-sum credit portion (nontaxable) and the interest portion (taxable). OPM will also withhold 20 percent federal income tax on the interest distributed. However, OPM will not withhold any federal income tax if the lump-sum credit refund applicant requests that OPM directly rollover the interest to a traditional IRA or to the traditional TSP. If the applicant requests that the interest be directly rolled over to a Roth IRA, then the entire amount of interest will be taxed in the current year.
If the entire refund of the lump-sum credit including interest paid by OPM is directly rolled over to a traditional IRA, then the lump-sum credit refund applicant is responsible for reporting to the traditional IRA custodian the taxable and non-taxable portions that are rolled over to the traditional IRA separately. Note that the TSP will not accept a direct rollover of the refunded lump-sum credit that includes interest paid by OPM.