Is Terminal Leave Deferral Worth the Wait?
What is Terminal Leave?
The subject of terminal leave is often a common topic discussed among FD-PD pre-retirees. Terminal leave is a benefit generally given to Service or Disability retirees. The benefit is equal to 3 terminal leave days for every year completed plus 1 terminal leave day for every 4 additional months completed. For example, a member who completes exactly 20 years would be entitled to 60 days (3 days x 20) of terminal leave. If the member completed 20 years and 4 months, they would be entitled to 61 days of terminal leave.
If a retiring FD-PD member is entitled to the terminal leave benefit, he or she has two choices:
“Take” the terminal leave. Taking terminal leave means the FD-PD member has elected to not work and will receive a terminal leave paycheck(s) until the terminal leave is exhausted.
Elect terminal leave lump-sum. This FD-PD member has elected to continue to work (or take vacation time, other leaves, etc.) to get to their specific retirement date. This member will receive the value of the terminal leave days as a lump-sum payment after his/her retirement. The terminal leave lump sum is not a “retirement plan” that is rolled over, but simply a paycheck. Since it is a paycheck, the pre-retiree has the option to tax defer some of the terminal leave lump-sum to the NYC Deferred Compensation 457(b) and/or 401(k) plans.
Taxation of Terminal Leave Lump-sum
Terminal leave lump-sum payments are considered supplemental wages by the IRS. The federal tax supplemental withholding rate is currently 22%. It should be noted that withholding rates are not your tax rate. Your tax rate is determined when you file your taxes. An approximate estimate for NYS/NYC withholding is 11%. The terminal leave lump-sum payment is also subject to Social Security tax (6.2%) and Medicare tax (1.45%). If a member has already reached the maximum Social Security wage limit for the year, then the 6.2% tax is not withheld. There is no wage limit for Medicare tax, therefore everyone will be subject to the 1.45% tax.
Tax Deferral vs. Tax Savings
For some FD-PD pre-retirees there is no real tax savings by deferring some of the terminal leave lump-sum payment to the 457 and/or 401k. Eventually, the money deferred will be distributed from the 457/401k to the retiree and it will be taxed at ordinary income tax rates. Many FD-PD retirees will be in the same (or higher) federal tax bracket in retirement vs. when they were working. In some cases, a pre-retiree may have already deferred significant amounts of money into the 457/401k during their career and may be making their future “tax problem” worse by deferring some of the terminal leave lump-sum. Of course, some FD-PD members could be in a lower federal tax bracket in retirement vs. when working. An example would be a 3/4 retiree.
In some cases, deferring some of the terminal leave lump-sum payment into the 457/401k could result in a tax savings. An example would be a pre-retiree who is going to live in Florida in retirement. Since Florida does not currently have a state income tax, the retiree would not pay any NYS/NYC taxes on the money deferred.
NYC Deferred Compensation Plan Account Lock Down & Terminal Leave
The NYC Deferred Compensation Plan (NYCDCP) refers to terminal leave lump-sum as “Uniformed non-managerial lump-sum payment.” When a pre-retiree elects to defer some of their terminal leave lump-sum payment into their 457 and/or 401k, the NYCDCP “locks-down” the participant’s account at retirement. Many FD-PD members are not aware of this and are often very disappointed/annoyed that they do not have access to the 457/401k monies upon retirement. This lock-down period can be as long as 8 months! In general, it takes NYC about 4 to 6 months to issue the terminal leave lump-sum payment to the retiree and then it may take NYCDCP another 2 months to process any withdrawal or rollover request.
Is Terminal Leave Lump-sum Deferral Worth the Wait?
As reviewed earlier, for some FD-PD pre-retirees there may be no significant tax savings by deferring some of the terminal leave lump-sum payment. If the pre-retiree elects to not defer any of their terminal leave lump-sum into the 457/401k, the NYCDCP does not lock down the account. Since the retiree’s 457/401k is not locked down, the retiree has the option to withdraw/rollover their 457/401k in forty-five days. As per NYCDCP, a 457/401k participant’s distribution/rollover request will not be processed until forty-five days after their retirement date.
Can You Skip the Deferral and Take the Money?
Yes! Don’t forget to live a little bit and don’t become so obsessed with tax deferral. There is nothing wrong with paying taxes on the terminal leave lump-sum payment and going on a nice vacation, buy a gift for yourself, etc.
Conclusion
Tax deferrals do not necessarily equal tax savings, your taxes have just been deferred (postponed). The supplemental withholding tax of 22% is not your tax rate, it is just a withholding rate. Your actual tax rate is determined when you file your taxes.
Tax deferral on the terminal leave lump sum may, or may not, result in a realized tax saving. Any potential tax efficiency must be weighed against the cost in terms of a liquidity constraint, i.e., NYC DCP locking down your account. Account owners will not be able to withdraw money for supplemental income, or transfer money out of the plan.