It’s time for a little history lesson. Not just because it’s fun to run a rake through the past, but because it can put things in perspective and clear up misunderstandings.
When I began working for the federal government, the U.S. tax code held that the retirement contributions deducted from your pay would be tax-free when you retired and began receiving an annuity. That’s because those dollars had already been taxed when they were earned. Only after those previously taxed dollars ran out did you begin receiving the government’s money. And that money was 100-percent taxable. The payout of the average retiree’s tax-free contributions took around 18 months.
That practice ended on July 1, 1986, when Congress changed the tax code. Henceforth, the tax-free portion of your annuity would be determined by your life expectancy at the time you retired. As a consequence, only a small proportion of your annuity would be tax-free and the rest would be taxable.
If you were a younger retiree, the time it would take to fully recover your contributions could exceed 30 years. Recognizing you might not live long enough to recover all of your contributions, the code specified that if you died before the tax-free portion was returned to you, it would be passed on to your spouse.
Then the tax code was changed again to factor in the age of the spouse at the time of retirement, thus further stretching out the time needed to fully recover the tax-free contributions. That change was effective for those retiring after November 18, 1996.
Any contributions that weren’t paid out to you when you died would be paid as a lump-sum death benefit according to the statutory order of precedence:
- To the widow(er); if none,
- To the child or children (in equal shares); if none,
- To the parent or parents (in equal shares); if none,
- To the duly appointed executor or administrator of the estate; if none,
- To the next of kin under the laws of domicile at time of death.
To determine when a death benefit is due, the Office of Personnel Management compares the gross amount it expended in annuity payments with the contributions you paid into the fund. When the tax code was changed, it did not alter that process. The only thing that changed was the way your annuity would be taxed.
Let me say that again, with emphasis. When the tax code was changed, it did not alter that process. The only thing that changed was the way it would be taxed.
In other words, while Congress changed the way your annuity are taxed, it didn’t change the way that OPM pays your annuity. As it has always done, OPM will return your contributions first. Only when that money runs out will you begin receiving the government’s money. Since the amount you contributed will run out fairly quickly, the tax-free portion of your spouse’s survivor annuity or the tax-free refund to your heirs will be far less than they might have expected.
For example, if you contributed $50,000 to the fund and received $50,000 or more back in annuity payments before dying and didn’t have a survivor spouse, no death benefit would be due. This is true despite the fact that you may have only received a portion of that amount tax-free before dying. To deal with this problem, the tax code provides that a deduction of the unrecovered tax-free portion of retirement contributions may be claimed on your final tax return as a miscellaneous itemized deduction. As such, it is not subject to the adjusted-gross-income limit.
Equally, if the unrecovered balance is passed through a survivor annuity and the survivor dies before the full tax-free amount has been recovered, the unrecovered portion may be claimed on the survivor’s final tax return.