As of February 2019, there were 3,715,215 FERS and CSRS participants in the Thrift Savings Plan.
However, only 557,470 people actually had money in the Roth TSP— only about 15% of all folks enrolled in the plan! Additionally, the average Roth balance for the FERS population was a paltry $13,336 compared to an average balance of $141,576 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 simply 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 #1 reason the Roth is not as popular is due to our ingrained beliefs and some 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 as our guiding principal, it makes since to take the tax break now through Pre-tax contributions and pay the tax later when we in retirement, enjoying a lower tax rate. (Remember, the Traditional TSP allows for Pre-tax contributions that grow tax deferred until you withdraw them in retirement)
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. Therefore, I’ve taken to championing the Roth TSP as something today’s Federal employee should consider for portion of their retirement. 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.
Here’s the how and why.
You may indeed earn less in taxable income while in retirement, but you may not be in a lower bracket.
The taxes you ultimately owe are not only based on your income, but also on your deductions. Yes, you most likely won’t be making as much in retirement, but you also won’t arrive in retirement without many of the tax deductions you enjoyed during your younger working years. The 2018 Tax Reform Act changed some of that, but the lesson remains. Tax credits for having children or tax deductions like mortgage interest often have a bigger impact that you think during your formative working years. People tend to make it a goal to have the house paid off and the kids long out of the basement when they’re ready enjoy their golden years. It’s great to arrive in retirement with those obligations behind you, but the tax deductions may be gone as well.
You may not pay more in taxes every year in retirement, but you could pay a lot more in certain years.
I live in Michigan and anyone who lives here knows that the winters can be absolutely brutal. Therefore, we have ‘snow birds’ in this state. These ‘birds’ are retirees that spend ½ of the year somewhere warmer, anywhere. Imagine this is you, you’ve had your eye on condo in Florida for some time now and you’ve decided to pull the trigger. You’ll need a need a chunk of money for a down payment or for the outright purchase of the condo. Where are you going to get it?
Well, 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. And the more you take, the more 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 money for income, the IRS doesn’t see it that way. 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. Maybe even as high a rate as when you were at your max earning years pre-retirement.
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 wants to pay off the loan right at retirement. Paying off the mortgage is a great strategy. You can free up a lot of 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 it all out of pre-tax account like a TSP or conventional 401(k). 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.
Simply put, 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 $203, 000 for married couples and $137,000 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 of Traditional IRA and 401(K) sources are counted towards the computation to determine if you owe tax on your SS. Yes, the more you take out of the TSP to more likely you will need to pay income tax on your SS 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 discussion of to “Roth or not to Roth” is based on your unique tax situation 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!
You should remember, the Roth IRA does have a few stipulations. In order to access the account tax free, you need to have reached the age of 59 ½ and have had the Roth TSP over at least 5 years.
However, we know enough to know that adding the Roth element to your overall retirement plan can add one valuable item to our plan: flexibility. Life in retirement is a lot like life now, full of changes, unforeseen problems and good opportunities.
By adding a “little Roth flexibility”, you may be able to better manage your taxes and your costs so you can truly enjoy your money in retirement.
After all, that’s why you retired in the first place right?
*Source: Thrift Savings Plan Fund Statitics, Thrift Savings Board, February 2019
** Source: TSP.gov ‘Purpose and History’
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