Why isn’t the Roth TSP more popular?
As of June 2020, there were 3,569,305 FERS participants in the Thrift Savings Plan.
However, only 666,175 people actually had money in the Roth TSP— only about 18% of all folks enrolled in the plan! Additionally, the average Roth balance for the FERS population was a paltry $15,740 compared to an average balance of $146,801 for the Traditional TSP.*
Why such a big divide between the two types of Thrift Savings Plans? Why no love for the Roth?
The obvious answer is that the ‘Traditional’ or ‘Pre-tax’ TSP has been around much longer. After all, the Roth TSP was only launched in 2012. The traditional TSP was launched in 1986. ** That may be part of it. But I don’t think it tells the whole story.
I believe the #1 reason the Roth TSP is less popular is because of long established ‘rules of the thumb’ that still govern retirement planning. The strongest of those beliefs is that we are automatically going to be in a lower tax bracket in retirement. With that belief dominating our thinking, it makes sense to take the tax break now and pay the tax later when we are in a lower tax bracket. (Remember, the Traditional TSP allows for pre-tax contributions that grow tax deferred until you withdraw them in retirement)
It’s not your fault if you believe this. It’s our fault. Financial experts, investment pundits and many of my fellow financial advisors have been ONLY recommending the pre-tax strategy for years. We in the financial world beat this drum so much that it is now taken as truth.
I believe that type of thinking is a bit misguided. There are plenty of reasons to think you may NOT be in a lower tax bracket at all times in retirement and paying the tax now may a better option. Therefore, I’ve taken to championing the Roth TSP as something today’s Federal employee should consider for a portion of their retirement. As a reminder, Roth contributions are made with after tax dollars which then grow tax free and can be withdrawn tax free in retirement.
We contend that by adding a slice of “Roth” to your TSP pie, you will add benefits and tax flexibility that will benefit you immensely later in life. I’ve listed below some of the biggest reasons or rationale that would support the Roth TSP over the traditional Pre-tax TSP.
You may have less taxable income while in retirement, but you may not be in a lower bracket.
The income taxes you owe yearly are not only based on your income, but also on your eligible deductions and credits. Although it is likely you won’t be earning as much in retirement, you also won’t arrive in retirement with as many tax deductions/credits you enjoyed during your younger working years. Tax credits for having children or tax deductions like mortgage interest often have a bigger impact that you think during your formative working years
Furthermore, tax law is fluid. Congress could, and has changed tax law. Most recently, the 2017 Tax Cut and Jobs Act (TCJA) lowered taxes for many but this law is set to expire in 2026. For example, the TCJA doubled the current standard deduction and lowered tax brackets for many Americans. When the TCJA tax law sunsets in 6 years, the higher standard deduction will disappear and higher brackets will reappear if Congress doesn’t act before. Will you be in retired when that happens?
You may pay more in taxes each year in retirement, but you could pay a lot more in certain years.
I reside in Michigan and anyone who lives here knows that Great Lakes winters can be absolutely brutal. Therefore, we have ‘snow birds’ that like to fly south each year to warmer climates. These ‘birds’ are retirees that spend large parts of the year in more friendly climates. Imagine this is you, you’ve had your eye on condo in Florida for some time now and you’ve decided buy it. You’ll need a need a chunk of money for a down payment. Where are you going to get the funds?
If the biggest and only account at your disposal is your Traditional TSP, you may be forced to use that account as the source of that down payment.
Here’s the rub. Every dollar you withdraw from the Traditional TSP is taxed at ordinary income. Because we have a progressive tax rate system, the more you make (or take) the greater percentage you are taxed. The IRS does not care if you are using your TSP for basic retirement income or a boat. In this ‘condo’ case, although you are technically not using that withdrawal for income, the IRS still taxes it as income. Even withdrawals of $30,000 or more in excess of your normal withdrawals and FERS/CSRS pension can force you into a higher tax rate. Having a pot of ‘tax free’ Roth money would allow you to take a substantial lump sum withdrawal and not impact your taxes at all.
Having a Roth TSP allows you to pay off big bills in retirement at potentially lower costs.
I even found this strange at first, but it’s true. We see this when a person retires with a mortgage balance and wants to pay off the loan right at retirement. Paying off the mortgage is a great strategy. You can free excess cash flow and the feeling of satisfaction in paying off a mortgage is tremendous. On the surface, this sounds like an excellent plan.
However, it could cost you more in taxes if you need to withdraw the remaining balance from of pre-tax account. Similar to my condo example, using a ‘traditional only’ TSP account to pay off a loan may place you in a higher tax bracket. Consider this higher tax bracket an extra ‘fee.’ We know most of us hate fees. The excess tax you incur for making the withdrawal is a sunk cost you’ll never get back.
For higher earners, the only way to contribute money tax free via a Roth is through the TSP
The IRS imposes income limits on Roth IRA eligibility. If you wanted to take advantage of the “Roth” outside of the TSP, you lose that ability if you make more than $206 000 for married couples and $139,000 for single filers.
Distributions out of a Roth TSP don’t affect the taxation of your Social Security.
When determining the percentage of your social security subject to income tax, distributions from a Traditional IRA, TSP or 401(K) are counted towards the computation to determine if you owe tax on your Social Security. Yes, the more you take out of the TSP the more likely you will pay income tax on most of your Social Security check. Distributions from Roth sources have no impact whatsoever.
In the end, it’s difficult to say with 100% certainty that one strategy is better than the other for all people. Ultimately, the decision of to “Roth or not to Roth” is based on your unique tax situation, your need for income in retirement, current tax law and your projected future tax bracket. We know that taxes can go up, go down or stay the same. Of course, if we knew exactly, which direction they were headed, our decisions would be clearer!
However, we know enough right now that adding a Roth component to your overall retirement portfolio can add one valuable item to your plan: flexibility. Life in retirement is a lot like life now, full of changes, unforeseen problems and good opportunities. If 2020 has reminded us of anything, it’s that the future is uncertain. Best be prepared.
By adding a “little Roth flexibility”, you may be able to better manage your taxes while provide spending flexibility so you can truly enjoy your money in retirement.
After all, that’s why you retired in the first place right?
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** Source: TSP.gov ‘Purpose and History’
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Securities America and its representatives do not provide tax advice; therefore it is important to coordinate with your tax advisor regarding your specific situation.