oversight

Tax Policy: Taxation of Pension Income for Retired New Jersey Police and Firefighters

Published by the Government Accountability Office on 1990-04-13.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

       lIrlitctcf States   General   Accounting   Offiw             __ll---
iSA0   1Sriefing Report to Congressional
       Requesters



       TAX POLICY
       Taxation of Pension
       Income for Retired
       New Jersey Police and
       Firefighters
                                                                    ii
                                                          lllllIIll1
                                                           141129
                                                                  I
      United State6
GAO   General Accounting Office
      Washington, D.C. 20548

      General Government Division
      B-237901

      April 13,199O


      The Honorable        Bill  Bradley
      United States        Senate
      The Honorable        Frank R. Lautenberg
      United States        Senate
      At your request,       we evaluated    the fairness    of the actuarial
      tables    used by the Internal       Revenue Service     (IRS) in
      computing      taxable   pension income and the feasibility        of using
      actuarial     tables   that take into account occupation         and other
      factors.      We briefed    your offices     on these matters    and, as
      agreed,    this briefing      report details    the information
      presented.
      BACKGROUND
      Pension income is partially       tax-free   if employees contribute
      to their  retirement    plans.   The tax-free     portion   is based on
      employee contributions      and the life    expectancy    of the
      employee at retirement.
      In calculating         the taxable         portion      of pension        income the
      Internal      Revenue Code allows retirees                   to deduct their
      contributions        from their         retirement        income, thereby         reducing
      their    taxable     income.         The deduction         of contributions,
      however,      is prorated        over a number of years;                the number is
      determined      by the life          expectancies        of the retirees          at
      retirement.        Shorter       life     expectancies         mean that more of the
      amount contributed            is recovered         in the early years of
      retirement       and, therefore,           taxable      pension      income is lower
      in those years.           However, shorter           life      expectancies       also
      mean that pension           income becomes fully               taxable      sooner.    The
      timing,     but not the amount, of taxes paid on pension income
      depends on life          expectancies.
      The Treasury    mandates the use of one table of life
      expectancies     for retirees    who made contributions     before July
      1986.    For retirees     who made contributions      after June 1986,
      it mandates the use of an updated table of longer life
      expectancies.       And, if retirees   made contributions      before and
B-237901




after July 1986,         they may use the shorter              life  expectancies
for contributions          made before July 1986,             and the longer ones
for contributions          made after  June 1986.
In addition      to the rules mandated by Treasury,                    IRS allows
retirees     to use the simplified             general     rule.     Under this
rule,    one life      expectancy      is applied      to all contributions
instead of applying           the shorter        and longer life        expectancies
to the contributions            made before and after            July 1986.         Both
sets of rules are described                in the IRS Publication            575,
Pension and Annuity           Income.        According     to the New Jersey
Policemen's       Benevolent       Association,       police     and firefiqhters
have shorter       life    expectancies        than the general         population.
The Association         believes     that if police          and firefighters
could use actuarial           tables     reflecting      their    shorter      life
expectancy,      their     taxable     income and, therefore,            their      taxes
in the early years of retirement                  would be less than under
current    law.
RESULTS IN BRIEF
Our analysis       showed the       following:
-- The life     expectancies       we estimated    for New Jersey police
   and firefighters         are the same as those of the general
   population,        but are shorter     than the life       expectancies   in
   IRS' updated table.            However, the effect       of using the IRS
   updated table         can be offset    if the retirees       use the table
   of shorter      life    expectancies     for contributions       made
   before July 1986.
em Using our estimates          of New Jersey police      and firefighters'
   life   expectancies      rather     than the IRS updated table to
   prorate    contributions        made after June 1986 would result        in
   a slight    reduction      in taxable      pension income in the early
   years of retirement,          followed     by 1 or more years of
   increased     taxable    income.       In our example of a 55 year-old
   male retiring       on July 1, 1989, with 30 years of service,
   the present      value of the savings would be $108, which is
   less than 1 percent          of the present value      of the pension
   received    over the recovery          period.
-- The total     amount of taxes paid by retirees     over the
   recovery    period    would be the same no matter what life
   expectancy     table   is used.   Thus, if lower taxes are paid
   in the early      years of retirement   due to shorter    life
   expectancies,      more are paid later.    Actual  savings arise
2
B-237901



     from the time value of money.          Using the same example of
    the 55 year-old     retiree     and the life   expectancies     for New
    Jersey police     and firefighters      rather than the IRS updated
    table to prorate     contributions,      would reduce taxes by $17
    per year for 22 years.          However, in the twenty-third        year,
    the retiree   would have a tax increase         of $374.     After
    that,  the entire    pension becomes taxable.
We do not believe         that the relatively         small tax savings
warrants      a separate     table    of life   expectancies     for police
and firefighters.           Not only are their        life  expectancies
substantially       the same as those of the general             population,
but developing        separate     tables    would create a troublesome
precedent      since other occupational           or demographic     groups may
request their       own tables.         This would complicate
administration        and create      confusion    for taxpayers     who could
fall   into several       of these different        groups.
We found that IRS guidance             in Publication     575 does not say
when using the simplified             general   rule is to retirees'
advantage.       Retirees      whose employers cannot determine
contributions       made before and after          1986 would be better    off
using the simplified           general     rule because they would pay
fewer taxes in the early            years of retirement.        However, the
publication      directs     these retirees      to use the updated table
of longer life        expectancies       for all contributions.
Retirees,     therefore,       will   pay more taxes in the early years
of retirement.
For retirees     who do know their        contributions    made before
July 1986, Publication         575 does not indicate       that,    in some
cases,    using the simplified       general     rule may also be to their
advantage.      Our analysis      showed that whether the rule does
work to the advantage        of retirees      depends on (1) the
proportion     of total  contributions        made after   July 1986, (2)
gender, and (3) aqe at retirement.               In order to determine      if
using the simplified       general     rule is to a particular
retiree's     advantage,   retirees     must compute their       taxable
pension income using both actuarial              tables  and compare that
income to the taxable        income using the simplified           general
rule.
RECOMMENDATION
The Commissioner,   Internal  Revenue Service,     should revise  IRS
Publication  575 to clarify   when retirees     can use the
simplified  general   rule to their  advantage.     If retirees  do
3
B-237901




know their      contributions     made before and after        July 1986,
they should be instructed           that the use of the simplified
general     rule may or may not be to their           advantage.    The
publication      should also instruct       retirees,    whose employers
cannot separate        the contributions     they made, to use the
simplified      general     rule because it is always to their
advantage to do so.
OBJECTIVES,     SCOPE, AND METHODOLOGY
Our objectives      were to review the fairness   of the current
actuarial    tables   used by IRS and to evaluate    an alternative
approach advocated      by the New Jersey Policemen's    Benevolent
Association     that takes into account occupational     and other
variables.
To accomplish         the first     objective,      we compared the actuarial
tables    used by IRS with actuarial              tables    for the general
U.S. population.            To accomplish      the second objective,       we
estimated     life      expectancies      for retired      New Jersey police
and firefighters,           using standard       actuarial     procedures  from
data provided         by The Prudential        Insurance      Company of
America.      Limitations        to the 'use of the data are discussed
in appendix        I.
We then calculated      the potential      tax savings available     to
the police   and firefighters       if they calculated      their taxable
income on the basis of our estimates            of their  life
expectancies    instead    of life    expectancies    used in IRS'
tables.
We interviewed       IRS and Treasury      Department      officials    to
obtain   information      on the actuarial     tables      used by the IRS
and to determine       their   views on the issues         raised    in this
report.
We  did our work between         February  and November 1989 and in
accordance  with generally         accepted government auditing
standards.
B-237901




AGENCY COMMENTS
We obtained   informal   comments from IRS officials.           They
agreed with   our conclusions    and recommendation.


As arranged     with your offices,     we are    sending copies of this
briefing    report   to the Joint Committee        on Taxation   and to
other interested       parties.    If you have     questions   about this
report,   pleased call me at 272-7904.           The major contributors
to this   report    are listed   in appendix     II.




Paul L. Posner
Associate  Director,    Tax Policy
  and Administration     Issues




                                                                            ,.
                                CONTENTS

                                                                        Page
LETTER                                                                    1

APPENDIX
               I   TAXATION OF RETIRED NEW JERSEY POLICE                  8
                     AND FIREFIGHTERS' PENSION INCOME
                        Background                                        8
                        What We Did                                      10
                        Taxable Pension Income Using the                 12
                           General Rule
                        New Jersey Policemen's          Associationts    14
                           Position     on Taxing Pension Income
                        Comparison of Life Expectancies                  16
                        Tax Savings Using New Jersey                     18
                           Police     and Firefighters'
                           Life Expectancies
                        Treasury's      Position    on Taxing            20
                           Pension Income of Police          and
                           Firefighters
                        Taxable Pension Income Using the                 22
                           Simplified     General Rule
                        Retirees      May Have Problems                  24
                           Understanding       IRS Guidance
                        Conclusions                                     26
                        Recommendation                                  28

          II       MAJOR CONTRIBUTORS TO THIS REPORT                     30

TABLES
    I.1            Tax Savings Using        New Jersey Police            18
                     and Firefighters’        Life Expectancies
    I.2            Percentage     of Total Contributions Made           22
                     After    July 1986 Needed to Use Simplified
                     General Rule to One's Advantage
FIGURE
    I. 1           Average   Life     Expectancy    at Ages SO-70        16

                                    ABBREVIATIONS
IRS Internal    Revenue Service
OPM Office    of Personnel  Management
            i


7
APPENDIX I                                           APPENDIX I



             TAXATION OF RETIRED NEW JERSEY POLICE
               AND FIREFIGHTERS' PENSION INCOME




    GAD Background

                                                1



              Recovery of contributions
              to pensions and annuities




8
APPENDIX I                                                                   APPENDIX I



BACKGROUND
Pension and annuity         income may be fully        taxable   or only
partially   taxable.        They are fully     taxable     if, during their
employment,    individuals       make no contributions         to their
retirement    plans.      If contributions       are made with income that
has been taxed, then retirement            income is only partially
taxable.    The contributions         are not taxed when recovered         after
retirement.
For all retirees    with a pension starting      date after      July           1,
1986, recovery    of contributions     is spread over the life
expectancy   of the retiree.       The division  between taxable                and
nontaxable   income is based on an employee's        contributions               to the
pension and the expected return        from it.
The expected      return    is the total     income a retiree     can expect to
receive   from the pension.          It is determined     by multiplying     the
annual pension       income by the retiree's         life expectancy     as of the
annuity   starting      date.     The life   expectancy   is taken from
actuarial    tables     prescribed     by the IRS.
In general,      shorter      life  expectancies      mean that taxpayers         will
pay less tax in the initial            years of retirement           because a greater
share of their        contributions      would be deducted         from total     taxable
pension    income in those years.            However, use of the life
expectancies        in the IRS actuarial        tables   affects      only the timing,
not the total        amount, of taxable       income recognized          by retirees.
Therefore,      assuming the same tax rate, the total                 taxes paid over
the years would remain the same.                This is so even if retirees            die
before they recover all their             contributions.         In these cases, a
deduction     for the unrecovered         contributions      may be taken on the
retiree's     final    income tax return.
APPENDIX I                             APPENDIX I   '




GAQ What We Did

          l   Reviewed actuarial tables
              Gompared IRS tables with
               other tables
          l   Evaluated alternative approach
              @Estimatedlife expectancies
              of NJ police and firefighters
              *Estimated tax savings for
               NJ police and firefighters

      Y




10
        APPENDIX I                                                                    APPENDIX I



        WHAT WE DID
        Our objectives          were to review the fairness    of the actuarial
        tables      currently     used by the IRS and to evaluate    the
        desirability          of an alternative   approach advocated   by the New
        Jersey Policemen's          Benevolent   Association that takes into
        account occupational           and other variables.
        To accomplish          the first      objective,     we compared the actuarial
        tables      used by IRS with tables              for the general   U.S. population        as
;:p.    published      by the National           Center for Health Statistics,
        Department        of Health and Human Services.               The center's
        statistics      --the most current           data available     on life    expectancies
        of the U.S. population--              are from the U.S. Decennial          Life Tables
        for 1979-81.           To accomplish       the second objective,        we obtained
        exposure1       and death data on retired              New Jersey police      and
        firefighters         for the period July 1, 1987, to July 1, 1988, from
        The Prudential           Insurance     Company of America.        Prudential      carries
        the group life           insurance     coverage for New Jersey's         Police and
        Firemen's       Retirement       System.

        Using the data, we were able to estimate         life   expectancies     for
        the retired  police and firefighters      using standard       actuarial
        techniques.   We compared their      life expectancies      with life
        expectancies  of the general     U.S. population      and those used by the
        IRS.
        We then estimated       the potential      tax savings that would be
        available     to the police    and firefighters       if they calculated
        their    taxable   income according      to life   expectancies   we estimated
        instead     of those prescribed       by the IRS for prorating
        contributions      made after   July 1986.
        We interviewed    IRS and Treasury     Department officials to obtain
        information    on the actuarial   tables   used by the IRS and their
        views on the issues raised in the report.
        An important    limitation       to our report       is that the amount of data
        on retired    New Jersey police         and firefighters        is small.    The data
        provided   by Prudential        included   9,399 lives        exposed and 139
        deaths.    Thus, current       and future     life     expectancies    of retired
        New Jersey police        and firefighters        could be higher      or lower than
        our estimates.


        1"Exposure"  is the        number of persons        subject     to death     in a given
        period of time.




       11
 APPENDIX I                     APPENDIX I   '   s




GM Taxable Pension Income Using
   The General Rule
       *Taxpayers may “usethe life
        expectancies in the 1954
        IRS table, the 1986 IRS
        table, or both to calculate
        taxable income depending on
        when they made contributions.




12
     APPENDIX I                                                                    APPENDIX I



     TAXABLE PENSION INCOME USING THE GENERAL RULE
     Taxable pension    income may be calculated    according   to the
     general   rule or the simplified   general  rule.     Both rules are
     discussed    in IRS Publication  575, Pension and Annuity      Income.
     Under the general        rule,   retirees       must elect    to use the life
     expectancies    in IRS table         I, IRS table V, or both in figuring                the
     taxable   part of pension        income.        IRS first   adopted table         I in
      1954 and table     V in 1986.         The 1954 table has shorter            life
     expectancies    than the 1986 table.2               By choosing     the 1954 table
     instead of the 1986 table,             retirees     recover their      contributions
     over a shorter      time period.          For example, a male retiree,             age 60
     at retirement,      could recover his contributions               in 18 years (using
     the 1954 table)       instead   of 24 years (using the 1986 table).                    This
     would lower the retiree's           taxable      income and, thus, the retiree's
     taxes for the first         18 years,       but increase    them for the next 6
     years.    The total      taxes paid would remain the same over the 24-
     year period,    but the timing          of the tax payments would change.
     Retirees  who made all their  contributions                to their     pensions
     before July 1986 may use either     actuarial              table.
     Retirees     who made contributions       to a pension before and after
     July 1, 1986, may choose to use both tables.              To calcurate     their
     taxable     pension income these retirees        may use the 1954 table       for
     contributions      made before July 1986, but must use the 1986 table
     for contributions      made after     June 1986.    If retirees    do not know
     how much they contributed         before July 1986, they must use either
     the 1986 table      for all contributions      or the simplified      general
     rule.      (This rule is explained      on page 24.)
     In general,     the greater      the proportion      of contributions made
     after    June 1986, the greater          the length of time needed to
     recover contributions.           To continue     the example used above, if
     one-half    the contributions         were made before July 1986, retirees
     would recover their        contributions       in 20.6 years instead  of 18
     years by using the 1954 table or 24 years by using the 1986
     table.     Again, total     taxes paid would remain the same over the
     recovery period;      only the timing        of the payments would change.



     2Both tables   consist  of life    expectancies    for a single    life.
     There are other tables     for joint    and survivor   pensions,     temporary
     pensions,   and the present    value of any guaranteed       refund feature.




13
     APPENDIX I                         APPENDIX I        -




G&I NJ Policemen’s Ass’n Position
    On Taxing Pension Income
               *Shorter life expectancy of
                police and firefighters
               aTaxable portion of pension
                income is too high
               *Separate actuarial tables for
                police and firefighters needed




           Y




14


                                                     ,.
     APPENDIX I                                                               APPENDIX I



     NEW JERSEY POLICEMEN'S BENEVOLENT ASSOCIATION'S
     POSITIO'N ON TAXING PENSION INCOME
 The New Jersey Policemen's             Benevolent     Association      believes      that
 the life     expectancy     of police     and firefighters        is shorter      than
 that of the general         population     because of the stress            of their
 occupation.        As a result,      they question      the fairness        of the IRS'
 actuarial     tables    used to calculate         the taxable     portion     of pension
 income.      The IRS tables      are used by everyone regardless                of what
 their    actual    life  expectancy      may be.
 The Association      believes    that because of their    lower life
 expectancy,     they will     not get back all of their     contributions    to
 their   pensions.     The Association     believes the taxable       portion of
 their   pensions will      thus be too high as will    the taxes paid on
 the pensions.
 The solution,     according    to the Association,      is to have the IRS
 prescribe     a separate    set of actuarial    tables    for use by police
 and firefighters       so that they may recoup their         contributions      over
 what they consider       a shorter   and more realistic       period     of time.




i5
     APPENDIX I                                                                                              APPENDIX I   .


GdU Comparison of Life
    Expectancies
                                                       Figure          1.1:
                        Averaqe              Life      Expectancy             at Ages 50-70




             so
             25


             20


             15


             10


              5


              0




                  1      1 Retired NW Jersey Police and Firefighters
                           U.S. Population
                           IRS: Table I, Ma!es. 1954
                           IRS: Table V. Unisex, IQ@

             Lie expectancies of retired New Jersey police and firdightW6 were computed by GAO from data
             supplied by The Prudential insurance Company of America.

             Life expectancies of US. population are from U.S. Decennial Life Tables for 1979-81, National
             Center for Health Statistiaj, U.S. Department of Health and Human Services.

             ~~m~~ctandes      used by IRS are from IRS Publication 575 (Rev. Nov. 88), Pension and Annuity




16
     APPENDIX I                                                               APPENDIX I




     COMPARISON OF LIFE EXPECTANCIES
     Our estimations      of the life     expectancies    of the New Jersey police
     and firefighters       are virtually    the same as those for the total
     U.S. population.        This means that police       officers      and
     firefighters,      once they retire,      have a life      expectancy    generally
     no different     than that of the general         population.       The life
     expectancies     for males in the IRS 1954 table,             however, are about
     2 years shorter      than those of the U.S. population,             while the life
     expectancies     in the IRS 1986 table are about 4 years longer.
     The IRS 1954 table          is based on the 1937 Standard Annuity          Table;
     the IRS 1986 table          is based on the 1983 annuity      table.     The 1986
     table is an updated actuarial            table that reflects     the increased
     projected      longevity      of the population.     The IRS also made it a
     unisex table because of Supreme Court rulings               on discrimination,
     according      to an IRS official.         The general effect    of the new
     table is to stretch           out the time needed to recover pension
     contributions,        particularly    for male retirees.
     The 1937 and 1983 annuity            tables  were developed by the Society          of
     Actuaries.       These tables       reflect  the lower mortality      experience
     of annuitants       rather    than the higher mortality      experience       of the
     total   population,       as in the U.S. life       table.  Annuitants      live
     longer,    on the average,        than the general population        because they
     tend to be in higher          socioeconomic     positions.   Also, it would
     not pay for a person in poor health,              for example, or in some
     other high-risk        category,     to purchase a life    annuity.3
     IRS officials      told us that the annuity          tables  were used to
     develop the life       expectancies      because they were the best tables
     available     for this purpose.        They said they were the best
     because they include        only the experience         of pensioners  and
     annuitants.       The U.S. life     tables    include    the mortality
     experience      of the entire     population,      not just pensioners   and
     annuitants.




     3By purchasing      a life    annuity   a person    receives  periodic
     payments,   usually      monthly    or annually,    for as long as he or she
     lives.




17
     APPENDIX I                                                                        APPENDIX I       *


 GAQ Tax Savings Using NJ P&F
     Life Expectancies
                                                 Table    1.1:
                            Tax Savings Using             New Jersey Police
                            and Firefighters'             Life Expectancies
                                                         Example    1   Example    2    Example     3
     Age at retirement                                       55             60               55

     Years    of service                                     30             35               30

     Retirement     date                                  7/l/89         7/l/94           7/l/96

     Annual    retirement       income                   $19,950        $26,200          $28,050

     Annual tax-free      portion                         $1,695         $2,699           $2,216
     splitting   contributions            under
     the general    rule
     Annual tax-free    portion       using               $1,755         $2,908           $2,440
     N.J. police    and firefighters'
     experience
     Additional  annual        tax-free                     $60            $209            $224
     income using N.J.
     experience
     Annual tax     savings         (assuming               $17            $59              $63
     28-percent     marginal         tax rate)
     Years    of lower      taxes                            22              19              23

     Years    of higher      taxes                            1              2                3

     Present value of tax savings                           $108           $330            $433
     over the recovery   period
     assuming an 8-percent
     interest rate
     Present value of pension                            $206,903       $262,440         $303,220
     income over recovery  period




18
     APPENDIX I                                                                     APPENDIX I



     TAX SAVINGS USING NEW JERSEY POLICE
     AND FIREFIGHTERS' LIFE EXPECTANCIES
     Our three examples show that the annual tax savings are small for
     male police    and firefighters,     using our estimate      of their   life
     expectancies     rather   than the IRS tables.      There are two reasons
     for this.     First,    New Jersey police   and firefighters      may use the
     IRS 1954 table for contributions         made before July 1986.       Second,
     the use of the tables        affects only the timing      of taxes paid, not
     the total    amount paid.
     While our estimated           life    expectancies      of New Jersey police          and
     firefighters        are lower than the life           expectancies        prescribed      in
     IRS' 1986 table,         they are higher         than those prescribed            in IRS'
      1954 table.         Because of this,       the police      and firefighters         would
     be able to save taxes in the early years of their                         pensions    by
     applying     their     own life     expectancies      to contributions         made after
     June 1986.         For those police        and firefighters        retiring      now or in
     the near future,         the proportion        of contributions         made after     June
      1986,    to those made before July 1986, will                be small.        In the
     examples,      their    contributions       are recovered       1 to 3 years sooner.
     The small reduction           in recovery      period leads to a small savings
     in taxes each year.
     For those police     and firefighters         retiring       in the      middle 19909,
     the use of their     own estimated       life    expectancies          instead  of the
     IRS 1986 table would produce greater                tax savings        in the early
     years of retirement.       However, as examples 2 and                  3 show, annual
     tax savings would still        be relatively          small,    $59    and $63.
     Even for police      and firefighters     who make all their
     contributions     after   1986 and retire    with 30 years service     in
     2016, for example, the annual tax savings in the early             years of
     retirement    would still      be small.   We estimate that the annual tax
     savings would be about $300.
     The use of the tables        affects      only the timing        of taxes paid, not
     the total     amount paid,     even if a retiree          dies before     recovering
     all contributions.         By recovering       contributions       sooner, and
     therefore     paying fewer taxes in the early years, a taxpayer's
     pension becomes fully        taxable      sooner.     For the later      years,
     accordingly,      the taxpayer     will    pay higher taxes than he or she
     would have if the contributions              had not been recovered          sooner.
     The amount of extra taxes paid in the later                   years will     just equal
     the taxes saved in the early            years.     In the examples,        this
     results    in a small present        value associated         with the payment of
     taxes later      rather  than sooner.         For example 3, the tax savings
     is less than 1 percent         of the present        value of the pension
     received     over the recovery       period.




19
     APPENDIX I                             APPENDIX I   -




     GAJ Treasury’s Position on Taxing
         Pension Income
                  *Prescribing multiple actuaria I
                   tables unworkable
                  4Jse of tables affects only
                   timing of income recognition
                  @Singleset of tables
                  balances considerations of
                  fairness and simplicity




20
APPENDIX I                                                                APPENDIX I



TREASURY'S POSITION ON TAXING PENSION
INCOME OF POLICE AND FIKEFIGHTERS
The Department of the Treasury             stated  in a letter    to Senator
Bradley,      dated March 11, 1988, that if the IRS were required              to
prescribe      a separate   set of actuarial       tables   for police    and
firefighters,       it would have no basis for failing          to prescribe
numerous sets of tables         for other groups on the basis of
occupation       or other characteristics,        such as gender,     race, or
health.
Treasury    said developing       multiple    tables    would be costly        and
their    use could produce disputes.            Would retirees       then be
allowed to choose the most favorable               table for themselves         on the
basis of just one of their          characteristics?          To elaborate      on
Treasury's     position,   would a retiree         who is a white female but in
poor health be able to use a table              of life     expectancies     on the
basis of all persons who are in poor health,                  or only females       in
poor health,     or only white females in poor health,                 or only
females,    or only white females?          Or a person could switch            from a
low-risk    to a high-risk      job before      retirement.       Which tables
would he or she be able to use? The Treasury believes                      that
prescribing     multiple   tables      would be unworkable.
Treasury also pointed         out that the use of actuarial            tables
neither    increases     nor decreases     the total      amount of taxable
income recognized        by retirees.      The use of actuarial          tables
affects   only the timing        of income recognition.           Treasury     pointed
out that if a retiree         dies before      recovering     the full     amount of
his or her contributions,           a deduction     for the unrecovered         amount
may be taken on his or her final             income tax return.          If, however,
the retiree     lives    longer than the actuarial          tables    project,     his
or her entire       pension becomes taxable         after the contributions
have been fully       recovered.
The total       amount of taxes paid by the retiree        would not increase
or decrease either:         only the timing     of payment would be affected.
If less tax is paid in the early            years of retirement     due to
shorter     life   expectancy,   more will    be paid in the later     years.
Treasury,       however, pointed    out that the timing      of income
recognition       and payment of taxes is important        to both the
taxpayer      and the government     because of time-value-of-money
considerations.
In summary, the Treasury       believes   that the use of a single        set of
actuarial   tables   properly   balances    the competing  considerations
of fairness    and simplicity     in determining   the proper timing       of
income recognition.        We agree.
     APPENDIX I                                                          APPENDIX I   .


w                Taxable Pension Income Using
                 The Simplified General Rule


                                          Table   1.2:             '
                     Percentage   of Total Contributions   Made
                    After  July j986 Needed to Use Simplified
                          General Rule to One's Advantage
         Age at                                            Aqe at
       Retirement            Percentage                  Retirement    Percentaqe
            55                  54.7                          66
            56                  12.7                          67          1:::
            57                  26.0                          68          27.3
            58                  39.2                          69          44.2
            59                  52.3                          70          59.8
            60                  64.5                          71           0.0
            61                  50.2                          72           0.0
            62                  62.3                          73           0.0
            63                  76.0                          74           0.0
            64                  88.0                          75          17.2
            65                 100.0

     Note:    Contributions       made by males after       June 30, 1986, for a
     pension based on a single         life,     must equal or exceed the above
     percentages     in order to use the simplified             general  rule
     advantageously       instead   of splitting     contributions      under the
     general   rule.




22
APPENDIX I                                                                    APPENDIX I



TAXABLE PENSION INCOME USING THE SIMPLIFIED                   GENERAL RULE
To make the calculation           of taxable     pension income simpler,             the
 IRS developed      the simplified       general    rule,    which many retirees
can use. 1 Under this         rule,    retirees     divide    their   total
contributions       by a number of months established               by the IRS to
determine      the amount of their        monthly pension        income that is
tax-free.        For example,    the life      expectancy     given by IRS for
retirees      age 55 or under is 300 months or 25 years.                    Retirees     do
not have to allocate        their    contributions        before and after         July
1986.

Life expectancies     under the simplified     general   rule are
generally    somewhere between the two life      expectancies    in the
1954 and 1986 tables,      but vary considerably     depending   on the                age
at retirement.
We developed       a formula       for determining        when to use the
simplified      general      rule in order to lower taxable             pension
 income.      We found that it is always advantageous                 to use the
simplified      general      rule instead      of the 1986 table,         if retirees    do
not know how much of their              contributions        were made before and
after     July 1986.       This would be the case, for example,                 if a
retiree's      employer      does not or cannot allocate            contributions
between the two periods.              However, it is not always advantageous
to use the simplified            general    rule if employers        do allocate
retirees'      contributions.         Whether or not it is advantageous
depends on gender and age at retirement.                       It is advantageous     if
the contributions          made after     June 1986, are equal to or greater
than a certain        percentage      of total      contributions.        Table I.2
shows the percentages            for male retirees         ages 55 to 75.
For example, to use the simplified                 general    rule to their
advantage,         males    who retired    at age 55 with a pension based on a
single     life     would have to have made 54.7 percent             or more of their
contributions          after   June 1986.     For age 65, the most common
retirement         age, it is never advantageous           to use the simplified
general       rule.      However, if he waits 1 year to retire           at age 66,
it is always advantageous               to use it.
For females with a pension based on a single          life,     it is always
advantageous    to use the simplified    general  rule except for those
retiring   between 63 and 65.      At age 63, a female would need 22
percent or more of her contributions       made after       June 1986 to use
the rule advantageously.      At age 64 it would be 60 percent;           at
age 65 it would never be advantageous.

1Conditiohs     for using the simplified            general     rule   are   in IRS
Publication     575, Pension and Annuity            Income.



23
     APPENDIX I                        APPENDIX I   '




GAO Retirees May Have Problems
    Understanding IRS Guidance
            0When retirees can separate
             their contributions
            0When retirees cannot
             separate their contributions




24
APPENDIX I                                                                APPENDIX I



RETIREES MAY HAVE PROBLEMS UNDERSTANDING IRS GUIDANCE
 IRS Publication      575 explains    how to report pension income on
federal     tax returns    and requires    retirees       to choose one of
several     methods for calculating      taxable        pension income.        It
contains      38 pages of instructions,       examples,       worksheets,      and
forms, and 66 pages of actuarial           tables.        While retirees       are told
it is to their       advantage   to separate     contributions        made before
and after      July 1986 to have a lower taxable             pension    income,
retirees      are not given instructions        on when they would lower
taxable     pension income by using the simplified               general    rule.    To
determine      which rule to use, retirees         need to know the amount of
contributions       made after   July 1, 1986.
When retirees       do know the amount of their            contributions     made
after    July 1986, the publication            does not inform then that it may
or may not be to their           advantage     to use the simplified        general
rule.     Our analysis      showed that whether it is depends on (1) the
proportion       of total   contributions        made after    July 1, 1986,       (2)
gender, and (3) age at retirement.                  In order to determine       if
using the simplified          general     rule is to their       advantage,   retirees
must compute their        taxable      pension    income using the IRS' 1986
table and compare that to the taxable                 income using the simplified
general     rule.
However, many organizations            do not provide      their       employees with
total    contributions       made after   July 1, 1986, according             to IRS and
Treasury officials.           For example,    the Office      of Personnel
Management (OPM) does not provide             such information           to federal
employees because the information             is not automated.             An OPM
official      said that federal      employees may request annual data on
salary     and contributions      from their     personnel       files     and calculate
contributions        made before July 1986.
When retirees   do not know the amount of their    contributions made
before July 1986, the publication     directs them to use the 1986
table for all contributions    even though using the simplified
general   rule would result in a lower taxable    pension income over
the recovery   period.




25
APPENDIX I                              APPENDIX I




  GdQ Conclusions

             0Separate life expectancy
              tables are not warranted
             l   In practice the IRS tables
                 are adequate
             0 IRS guidance is not clear
              on when retirees can use
              the simplified general rule
              to lower their taxable
              pension income



 26
I   APPENDIX I                                                               APPENDIX I



    CONCLUSIONS
    Separate      Life     Expectancy     Tables   Are Not Warranted
    In Treasury's     opinion,     the small present value of savings due to
    differences     in the timing     of tax payments and difficulties         of
    developing    and administering        specialized    tables   do not warrant
    IRS prescribing      different    life   expectancies      for police and
    firefighters.
    We agree.       Our position    is based on the low tax savings that
    would be available        to police   and firefighters      if they used the
    life    expectancies     we estimated    for New Jersey police         and
    firefighters       to calculate    the tax-free     portion   of their
    pensions,     rather   than the updated IRS tables.
    As Treasury     said,  and we agree, this would also create          a
    precedent    for others    to demand special    tables.     Treasury     said
    there would be substantial       administrative      costs and difficulties
    in developing      numerous sets of actuarial      tables   for the many
    groups that would claim different          life expectancies.
    In Practice          The IRS Tables     Are Adequate
    While the updated life     expectancies     prescribed          by the IRS were
    not developed    from the mortality     experience      of      all retirees,    and
    may therefore    be too high for some, their        use       is offset       if
    retirees   use the shorter   life   expectancies      for       contributions
    made before July 1986.
    Choosing The Most Advantageous
    Method For Calculating  Taxable
    Pension Income Is Not Clear
    IRS guidance       in Publication       575 on computing     the tax on pension
    income involves       several     alternative     methods for calculating     the
    tax.     We believe    many people would have difficulty            choosing the
    most advantageous       method.        For instance,    it is not clear when
    retirees    would find it advantageous            to use the simplified     general
    rule rather      than the general         rule.
    If retirees    can separate     their    contributions       made before and
    after    July 1986, use of the simplified            general   rule may or may
    not be to their      advantage.       If retirees      cannot separate   the
    contributions    they made, they are not instructed               to use the
    simplified    general    rule,  which would always be to their
    advantage.




    27
APPENDIX I                           APPENDIX I




w            Recommendation
                                                  -


             The Commissioner of the
             Internal Revenue Service
             should revise Publication 575
             to clarify when retirees should
             use the simplified general rule
             in order to reduce taxable
             pension income.




23
APPENDIX I                                                                  APPENDIX I



RECOMMENDATION
The Commissioner         of the Internal       Revenue Service should revise
publication       575 to clarify       when retirees     can use the simplified
general     rule to their       advantage.      If retirees     know the amount of
their    contributions        made before and after       July 1986, they should
be instructed        that the use of the simplified            general     rule may or
may not be to their           advantage.     In order to determine           if using
the simplified         general    rule is to their      advantage,     retirees     must
compute their        taxable    pension income using the IRS' 1986 table
and compare that to the taxable              income using the simplified
general     rule.      The publication      should also instruct         retirees,
whose employers         do not separate      the contributions       they made, to
use the simplified          general    rule because it is always to their
advantage to do so.




29
APPENDIX II                                                   APPENDIX II



                MAJOR CONTRIBUTORS TO THIS REPORT
GENERAL GOVERNMENTDIVISION,       WASHINGTON, D.C.
Charles Vehorn, Assistant      Director,   Tax Policy   and
    Administration  Issues
Charles Kilian,    Assignment    Manager
Linda Darby, Evaluator-in-Charge
MacDonald R. Phillips,     Economist
Bill   Simpson, Actuary




(268428)


      Y
I   .   .