9159 / What are some of the risks that members of the armed services should be aware of when planning for retirement?

The National Debt and Taxes

Having reviewed the main retirement income benefits available to retirees of the armed services – defined benefit pension plan with a survivor benefit option, service-related disability benefits, and the Thrift Savings Plan – it follows that an analysis of risks to that income receive some consideration. The first risk to consider is the role of federal income tax.

Since the inception of a federal income tax, the highest marginal rates have historically ranged from 94 percent to 28 percent, while effective tax rates have ranged from 82 percent to 18.6 percent.¹ The Tax Cuts and Jobs Act (TCJA) of 2017 reduced the top marginal tax bracket to 37 percent and raised the income limits that put individual and married taxpayers in that bracket. The standard deduction was doubled for taxpayers as well. The TCJA is scheduled to sunset on December 31, 2025, and the federal income tax rates in place and standard deductions prior to the enactment of the TCJA will resume.² Additionally, the TCJA could be repealed prior to its sunset based on changes in political control.

Adding to the likelihood of a higher federal income tax rate in the future is the burgeoning national debt. As of 2024, the national debt was recorded at about $35.7 trillion.³ This figure does not account for unfunded obligations such as government pensions, Social Security, interest on the U.S. debt, Medicaid, and Medicare.⁴ Several noted certified public accountants and PhD economists agree that the current debt trajectory will lead to a future requirement for the federal government to both reduce spending and increase revenue.

In 2010, Admiral Michael Mullen, former Chairman of the Joint Chiefs of Staff referred to the national debt as “the most significant threat to our national security.”⁵ Janet Yellen, the former Chair of the Federal Reserve and U.S. Treasury Secretary, commented in an interview that if she “had a magic wand, she would raise taxes” to address the national debt.⁶ David Wessel, Director of the Hutchins Center on Fiscal and Monetary Policy, cited Congressional Budget Office reports on projected debt levels to argue that both an increase in federal taxes and a decrease in spending obligations are necessary to stem the tide of further insolvency.⁷ A panel of economists, national security experts, and other subject matter experts including, among others, Madeleine Albright, James A. Baker, Henry Kissinger, George P. Shultz, Robert M. Gates, and Paul O’Neill recommended that federal taxes be increased as part of any plan to reduce the national debt.⁸

David Walker, a CPA and the former United States Comptroller General, said in an interview on National Public Radio, “[t]here’s absolutely no question that taxes are going to have to go up.”⁹ Walker argues that, absent significant action on spending and revenue, the math does not support the United States’ economic viability.¹⁰ To that end, he estimates that “federal taxes could double . . .”¹¹

Retiree Base Pay and Income Tax

If federal income tax rates increase significantly, retirees who rely on defined benefits pension plans and tax-deferred retirement plans risk seeing their after-tax income reduced and retirement savings depleted sooner than expected. Since a retiree’s base retirement pay is taxed as ordinary income, he or she will get to keep less of that pay. Unless the retiree’s cost of living is reduced by an equal amount, then the retiree will have a deficit that must be made up by withdrawals from his or her TSP. This decreases the principal of the TSP faster than contemplated and may lead to the retiree running out of savings during life.

Further exacerbating the income tax problem is that the retiree will likely have fewer deductions in the latter years of retirement. If the standard deduction reverts to pre-TCJA levels, then itemizing deductions becomes more appealing. At issue for many retirees is that the popular itemized deductions are state and local taxes, charitable contributions, interest paid, and unreimbursed expenses.¹² While people who are financially charitable during their working years are likely to still be charitable in retirement, it is entirely likely that a retiree may find that he or she has more time than money to donate to charity of their choosing.

The IRS does not provide a deduction for a taxpayer’s donated time. Additionally, many retirees have either paid their mortgages off prior to retirement or are primarily paying principal on the loan rather than deductible interest. Since they are no longer working, it logically follows that they do not amass unreimbursed expenses of note. State and local taxes, as well as medical expenses, may make itemizing expenses advisable for some retirees, but the benefit will not be as substantial as it was during their working years. In sum, retirees could have the same income in retirement as in their working years yet find themselves in a higher tax bracket, with the concomitantly reduced spending power, due to having fewer itemized deductions.

Social Security and Income Tax

Retirees from the Armed Services are entitled to receive Social Security benefits. While the calculations for benefits and age of eligibility to receive benefits are the same for military and civilian retirees, it is still relevant to the tax rate risk analysis of a military retiree to assess how the benefits may be taxed in retirement. Taxation of Social Security benefits may also have an impact on the retiree’s available funds in retirement.

The Social Security Administration determines the taxability, if any, of Social Security benefits by calculating what it refers to as provisional income. Provisional income is determined by first calculating a taxpayer’s modified adjusted gross income (MAGI) plus tax-free interest on municipal bonds. The taxpayer’s MAGI plus tax-free interest is then combined with one-half of the taxpayer’s Social Security benefits to arrive at the taxpayer’s provisional income. If provisional income exceeds certain thresholds, then up to 85 percent of the taxpayer’s Social Security benefits are taxed at the taxpayer’s marginal income tax rate.¹³

If a single taxpayer has a provisional income below $25,000, or $32,000 for married filing jointly, then none of their Social Security is taxed. If a single taxpayer has provisional income between $25,000 and $34,000, or between $32,000 and $44,000 for married filing jointly, then 50 percent of their Social Security is taxed. If a single taxpayer’s provisional income exceeds $34,000, or $44,000 for married filing jointly, then 85 percent of their Social Security is taxed.¹⁴ By receiving a pension, DoD retirees are essentially guaranteeing they will always pay tax on their Social Security benefits.

As a result of these provisional income thresholds remaining unchanged since their inception in 1984, a greater percent of retirees are paying income tax on their Social Security income today than in 1984.¹⁵ It follows then, that an even greater percent of retirees will pay income tax on their Social Security income in the future than do today. Retirees, military or civilian, will again have to evaluate the balance between reducing their cost of living requirements and withdrawing more from available, tax-deferred retirement accounts such as the TSP in order to make up for the increased tax burden.

The issue may become even more troublesome as the Social Security trust fund becomes more and more depleted. The Social Security Administration currently projects that it can pay full benefits for the Old Age and Survivors Insurance (OASI) only through 2034 with current funding. At present funding and projected contribution levels, benefits are projected to be provided at 76 percent of OASI scheduled benefits beginning in 2035.¹⁶ Receiving a quarter less of expected benefits and having 50 – 85 percent of those benefits taxed at increased level could clearly have a compounding effect on a retiree’s usable income in retirement.