For quite some time, the end of December has always been a favored period for federal employees to retire, and December 31, 2025, saw a notable wave of retirements among CSRS and FERS staff. It’s interesting to think that one reason behind this could be the opportunity to receive a lump-sum payment for their unused annual leave. These lump-sum payments are fully taxable and subject to federal and state income taxes, as well as Social Security and Medicare payroll taxes. Employees choosing to retire on December 31, 2025, will receive their lump sum in January 2026, deposited directly into the same bank account where their regular paychecks go. Additionally, they will get their final paycheck for the 25th pay period of the 2025 vacation year during the same month.
This column brings up an intriguing point: some federal employees retiring on December 31, 2025, who aim to continue working in 2026—whether as reemployed annuitants, with private companies, or as self-employed individuals—might temporarily lose some or all of their Social Security retirement benefits. This loss can be traced back to Social Security’s “means test.” The discussion also touches on how a retiring federal employee’s lump-sum payout for unused leave can affect the Social Security earnings test.
Regarding “earned income” and its influence on Social Security benefits, employees transitioning from federal jobs may start collecting monthly Social Security retirement benefits even while continuing to work. If they have at least 40 Social Security units, they are considered “fully insured” and can begin collecting benefits at 62. However, if a retiree is younger than their Full Retirement Age (FRA) and has earned income, the Social Security Administration (SSA) may reduce their monthly benefits accordingly.
FRA varies based on the year an individual was born. Once someone reaches their FRA month, they won’t face earnings tests anymore. Here’s how that breaks down:
– For those below FRA (born after December 31, 1959), they can earn up to $24,480 yearly (or $2,040 monthly) without penalty. For every $2 over this limit, their benefits will drop by $1.
– Those reaching FRA in 2026 can earn up to $65,160 per year (or $5,430 monthly) until they hit their FRA. Earnings exceeding that amount will also reduce their benefits, but at a different rate.
It’s also worth noting that the SSA applies two earnings tests annually, assessing individuals from ages 62 to their FRA, and again for those receiving benefits in the month just prior to reaching their FRA.
Just to clarify a few things:
1. Once someone reaches their FRA month, there’s no cap on earned income without affecting their Social Security benefits.
2. Only earned income counts; investment income, pension income, and certain other revenues don’t get included in the earnings test.
3. If someone loses their benefits due to the means test, there’s good news ahead—about a year after hitting their FRA, SSA recalibrates their benefits to reflect those months when they didn’t receive payments.
4. Importantly, earnings while receiving monthly benefits can actually elevate an individual’s future benefits, as SSA recalculates retirement benefits annually based on the highest income over 35 years.
Now, regarding the timing of salaries or wages, it’s crucial to remember that the SSA considers income based on when it’s earned, not paid. So if an employee agrees to defer payment for work to the following year, that income won’t count against the earning limits for the year it’s received.
For employees departing at the end of December 2025, they can expect a “special payment” for work done before beginning to receive Social Security benefits, which is not subjected to the earnings test. This includes the final paycheck for the 25th pay period of 2025 and a lump sum for any unused annual leave they have accrued.
As a case in point, consider Cynthia, who is set to retire on December 31, 2025, after 32 years of service. At her retirement, she has 440 hours of unused leave, which will be paid out in January 2026 along with her last paycheck. This means these payments will not count towards her 2026 income limit for the Social Security earnings test because they were earned in 2025.
Cynthia should also ensure she files the appropriate form to communicate this information to the SSA, which will help maintain her benefits without being impacted by those payments.
Please note that the information shared here is for general purposes and should not be seen as professional advice. If specific guidance is needed, it’s always best to consult a qualified professional.
