It's Never Too Early to Plan for Retirement: Important Changes to Roth TSP
Friday, March 11, 2016
Posted by: CDR Shad Thomas, USCG and LT Robert Shaye, USCGR
Traditional vs. Roth Thrift Savings Plan
A closer look at the two options available for TSP contributions
By CDR Shad Thomas, USCG and LT Robert Shaye, USCG (Reserve)
The Thrift Savings Plan (TSP), the Federal Government and military’s version of the 401(k), is a fantastic, low-fee way to save for retirement. The plan has recently added a new option for making contributions, yet the benefits of this feature are not widely understood. The “Roth” option was introduced to the TSP in 2012 and represented a significant alternative to making contributions to your TSP account. While “Traditional” (pre-tax) contributions are beneficial for some employees, Roth (after-tax) contributions offer a substantial advantage for those who are generally in a low tax bracket. Though the Roth option has been available for three years, many employees remain unaware of the advantages of it, and continue to make Traditional contributions to their TSP accounts, when potentially the Roth option may be more favorable. Choosing between the Traditional and the Roth options can have a substantial impact on the value of your retirement savings[KG1] . The objective of this article is to provide you with the information needed to make the best decision for your circumstances.
Traditional vs. Roth – The Basics
Traditional contributions are “pre-tax” contributions where the contribution is taken out of your paycheck before income is taxed. The money that is contributed to your TSP will grow, tax deferred, and you will pay taxes on your contribution and its earnings upon withdrawal in retirement. For example, if you make Traditional contributions of $5,000 into your TSP account in 2016 and that money grows to say $25,000 upon retirement, you will pay taxes on the $5,000 contribution plus the $20,000 in earnings when you withdraw them. If you are in the 28% marginal tax bracket in retirement and you withdraw that $25,000, you will pay 28% ($7,000) in taxes.
The Traditional option appeals to members who desire to lower their current taxable income. Using the previous example, an employee making a $5,000 Traditional contribution to their TSP account will lower their taxable income by $5,000 for 2016. As a general rule, if you think your tax rate will be less during retirement years than it is today, you may want to consider making Traditional contributions[KG2] .
Roth contributions are after-tax contributions, where the contribution is taxed during the current tax year. The money that is contributed to your TSP will grow tax-free and you will not pay taxes on contributions or earnings upon retirement. For example, if you make a Roth contribution of $5,000 that grows to $25,000 upon retirement, you will not have to pay taxes on either the $5,000 contribution or the $20,000 in earnings when you withdraw them during retirement, since taxes were paid on the initial contribution of $5,000.
Traditional vs. Roth – How to Decide
Now that we’ve covered the difference between Roth and Traditional contributions, let’s talk about how to decide between the two. It is important to remember, “Uncle Sam will always get paid,” meaning you are going to pay taxes one way or another on your TSP contributions. The difference involves when you are going to pay the taxes. As alluded to before, the crux of the debate is your current tax bracket and how it will compare to your tax bracket when you are in retirement. We examine three different scenarios to illustrate this point:
1. Your tax bracket now is the same as it is in retirement. If this were true, you would be completely indifferent to Traditional and Roth contributions and you would get the same amount of money in retirement. However, most people are not in the same tax bracket in retirement as they were during their working years.
2. Your tax bracket now is less than it will be in retirement. If this were true, you would prefer Roth contributions because you are paying your tax now and you would get more money in retirement than if you had made Traditional contributions.
3. Your tax bracket now is more than it will be in retirement. If this were true, you would prefer Traditional contributions because you are paying your tax later and you would get more money in retirement than if you had made Roth contributions.
The Case for Roth
“Okay, I got it. It all depends on my tax bracket now versus my tax bracket in retirement. But how will I know that?”
For active duty military members, it is important to note the significant tax breaks they receive. Specifically, certain allowances (Basic Allowance for Housing (BAH) and Basic Allowance for Subsistence (BAS)) are not included in taxable income. Depending on their BAH rate, this could mean active duty members are only taxed on about 65% of real income. For example, an O-3 with over 8 years of service stationed in Boston, MA receives a monthly Base Pay of $5,744; BAH (without dependents) is $2,892 and BAS is $253. This means their annual income is $106,700, but in the eyes of the IRS they only earn about $69,000. Effectively, they are only being taxed on 65% of their actual income, which puts the member in a lower tax bracket than if they held a comparable job in the civilian sector that paid approximately $106,700. Because military members are in such a low tax bracket now, it often makes sense to pay the taxes now (make Roth contributions). This is especially true if they’re planning on transitioning to the civilian world soon. Make Roth contributions now, because the taxes paid on them will be higher when they are working in a civilian job and not receiving the tax breaks on military allowances. Roth contributions may be an even better value if the member resides in a state that does not tax military income, which many military members have because of frequent permanent change of station transfers.
While civilian employees do not get the same tax breaks that military active duty members get, it may still be beneficial for civilian employees to make Roth contributions. The first step is reviewing your tax bracket and determining how much you’re paying in taxes each year. Civilians who are early in their career are likely to be in a low tax bracket and could benefit from Roth contributions. For civilian employees in the middle to latter part of their careers, even though they’re likely paying more taxes today, which suggests Traditional contributions, they may want to consider the Roth option due to the benefits of tax-free withdrawals in retirement.
Another reason to consider Roth contributions is to balance out any existing retirement savings. As we’ll explain later in the article, this “hedging option,” having some Roth and some Traditional dollars saved, provides more flexibility in retirement. Senior civilian employees are more likely to have Traditional dollars saved, mostly because Roth IRA’s and the Roth TSP are relatively new vehicles. So while it may be tempting to make Traditional contributions and benefit from the immediate tax break, saving Roth dollars could be a very smart move, in order to balance out existing savings.
Lastly, some civilians retired from 20+ years of active duty service and are currently working towards earning a second pension. Since they are already collecting their military pension plus their current civilian salary, their tax bracket is fairly high. Remember that both pensions count as federal taxable income in retirement too, and possibly towards state income depending on the state. It may be worth at least splitting contributions between Roth and Traditional to provide some flexibility, especially because Roth TSP contributions can be rolled into a Roth IRA to avoid Required Minimum Distributions (discussed below).
The Case for Traditional
While Roth contributions are better for most military members and some federal employees, let’s look at a few examples where Traditional contributions may be the better option:
1. You are married to a high-earning spouse and you file taxes jointly. Your spouse’s salary may be bumping you both into a high tax bracket now and perhaps you would benefit more from the tax-break of Traditional contributions.
2. You are senior in the government or military and have few deductions, Traditional contributions lower your current year tax liability.
3. You believe tax rates are going to decrease in the future or the tax law will change. (Tax brackets are at a historic low for most Americans. We certainly don’t hear discussion about the government having extra money laying around and reducing taxes in the future!).
The Roth Advantage
Another reason Roth contributions are attractive is due to a pesky little thing called RMDs or Required Minimum Distributions, which apply when you reach 70½ years of age. While that may seem like eternity, talk to any elderly person who is financially well-off and they will tell you how annoying RMDs are. In short, the government requires you to withdraw money from your accounts and add to your taxable income, even if you don’t need or want the money. RMDs apply to Traditional 401(k)s/TSPs, Traditional IRAs, and Roth 401(k)s/TSPs. Roth IRAs do not have RMDs. How does that help? Well, when you leave government service and if you are concerned about forcibly taking income, you could roll your Roth TSP into a Roth IRA and therefore exclude it from RMDs.
Roth accounts are also beneficial because of their superior wealth transfer benefits for passing money down to future generations. There are many nuances with Inherited IRAs, including if the beneficiary is a spouse or non-spouse, and how long the money has been in the account. Without going into all the details, leaving your heirs a Roth account is far better because there are no taxes on the distributions they must take from the account. Distributions from Traditional accounts, in contrast, are taxed at your heirs’ current tax bracket. This can be very costly if, for example, your daughter is a high earner and already in a high tax-bracket. She would have to pay taxes on the distributions at her current tax-bracket, which leaves less money to her in the end. Had you left her a Roth account, all those distributions would be tax-free.
If you are unsure about switching to Roth, consider hedging your tax exposure by contributing some to Traditional and some to Roth. For example, you could make $9,000 of each type of contribution, thereby getting somewhat of a tax-break now, but also saving some money tax-free. Alternatively, you could hedge by holding a Roth IRA and a Traditional TSP. This method also gives you more options in retirement regarding from which accounts to draw your money. By having some money in a Traditional account, some in a Roth, and some in a taxable account, you can choose which account to draw from each year depending on your financial situation and tax bracket at that time.
Your TSP Account
It is important to note that when you switch contributions from Traditional to Roth, you will have two separate balances, or “buckets” of money in your TSP account: The Traditional bucket, which still has a tax liability, and the Roth bucket, which does not. The Traditional portion will continue to grow based on your fund allocation even though you’re no longer making Traditional contributions. Under current TSP rules, you cannot convert your existing Traditional TSP balance to your Roth TSP. If the rules change and this is allowed in the future, you will have to pay taxes on the Traditional balance of the conversion at your tax rate during the year of the transfer. In addition, agency contributions (matching funds) are deposited into the traditional bucket.
Additional Retirement Account Information
Aside from the Roth vs. Traditional analysis, here are some other very important considerations for your retirement accounts:
1. The TSP contribution limit in 2016 is $18,000 (with an additional $6,000 ($24,000 total) if you are age 50 or older). This is completely separate from the $5,500 IRA limit (or $6,500 if you are age 50 or older). If you can afford it, you can squirrel away $23,500 in retirement savings per year. To be clear on Roth contributions, if you are under the age of 50, in 2016 you can contribute $18,000 to your Roth TSP and $5,500 to your Roth IRA. This is a tremendous tax advantage for many active duty members!
2. Don’t let your money sit in the G Fund, which is the default fund for uniformed services members upon enrollment in the TSP. While safe, it barely keeps up with inflation. If you have a 15-20 year horizon until you need the money, consider a Lifecycle Fund that aligns with your projected date of needing the funds in retirement. Beginning this year, the L Funds will be the default option for civilian employees upon enrollment in the TSP. Hopefully the same rules will follow suit for military members in the near future.
3. Overall the TSP is a fantastic way for us to save, but it does fall short in some areas. Most notably, there are only five fund choices, with no exposure to Emerging Markets, TIPS (Treasury Inflation Protected Securities), or REITs (Real Estate Investment Trusts). Well-diversified portfolios have lower volatility, so consider getting some exposure to these in your non-TSP accounts, such as your IRA, by using low-cost, indexed, exchange traded funds (ETFs).
4. TSP and IRA investments offer us substantial tax advantages over the long run. However, retirement accounts are illiquid assets and there is a significant penalty for withdrawing funds prior to age 59½. Therefore, the TSP and IRA should not be relied upon for short-term expenses (i.e. making a down payment on a house or paying off credit card debt).
5. If you’re military and transferring out of the service, do not immediately roll your TSP into an IRA. Many financial advisors will try to convince you to do so, because they stand to gain financially if you do. Sadly, many military members do this every year, only to be exposed to fees that are often 10-20 times higher than the TSP. (The TSP has the lowest fees in the industry, averaging 2.9 basis points, or 29 cents for every $1,000 invested).
Managing your TSP
Perhaps one of the most critical decisions to make with your TSP is the decision between Roth and Traditional contributions. Switching from Traditional contributions to Roth contributions requires us to change our strategy for retirement savings, which can be difficult to do. A high percentage of active duty members and civilian employees that we’ve trained have a Roth IRA and a Traditional TSP, because Traditional was the only option they had when they established their TSP account. They’ve built a successful strategy with their retirement accounts and are on track for a healthy retirement. However, we would argue that they should consider making Roth contributions to their TSP account to optimize for the future and greatly enhance their retirement strategy.
CDR Shad Thomas is a 1998 graduate of the U.S. Coast Guard Academy and holds an MBA from Vanderbilt University Owen Graduate School of Management. He has commanded the cutters POINT BRIDGE, HALIBUT, TYBEE, and KISKA. He currently serves as the Financial Management Program Manager at Coast Guard Headquarters. He is a Certified Government Financial Manager and former President of ASMC Aloha Chapter.
LT Robert Shaye is a 2004 graduate of the U.S. Coast Guard Academy and holds an MBA from the UC Berkeley Haas School of Business. He was Active Duty in the Coast Guard for 10 years and served aboard cutter TAHOMA and Barque EAGLE. He is now the Director of Customer Education at FutureAdvisor in San Francisco, where he teaches others how to invest smartly and save for retirement.