Byron thought he was doing “the retirement planning thing” right.
He worked hard. He saved diligently. He watched the money in his traditional TSP grow and grow and grow.
But now he’s discovering a nasty surprise: His big TSP “nest egg” may ultimately result in some negative tax consequences.
In this blog post (and companion video), we’re looking at four reasons folks like Byron might want to avoid putting money into a traditional TSP.
Reason #1: You can avoid potential tax increases.
When you put money into a traditional TSP (or IRA), you get a tax deduction now, plus tax-deferred growth over time; however, when you take distributions in the future, you will have to pay taxes on those withdrawals.
And you’ll pay at whatever the tax rate is at that time. It’s possible–some would say “likely”–that tax rates will be higher in the future. If that happens, utilizing a Roth TSP is the better choice.
Sure, you’ll have to go ahead and pay taxes now, but you’ll avoid the possibility of higher taxes in the future. That’s one reason to avoid traditional TSP: You believe future tax rates will be higher.
Reason #2: You can avoid mandatory distributions in life.
At some point, you will be forced to take money out of your TSP account. These mandatory withdrawals are called required minimum distributions (RMDs). They begin at age 73 (for those born 1951-1959) or age 75 (for those born in 1960 or later).
The beginning distributions are around 4% of whatever your account balance is, and you have to take the money out each year. Again, you have no choice in this matter, and all these withdrawals are taxable. Whether you need the distribution or not, these withdrawals are mandatory.
Reason #3: You can avoid mandatory distributions after death.
Let’s say that at your passing, your spouse inherits your traditional TSP–or traditional IRA. They can roll that money into their personal account. However, if you’ve already started taking RMDs, they will be required to continue taking those annual distributions. And of course, those withdrawals are taxable.
If you have a non-spouse beneficiary, there’s a 10-year rule. This rule stipulates that they must take a minimum amount out each year and the full balance must be withdrawn by the end of the 10th year. Again, all these distributions will be taxable.
Reason #4: You probably won’t be in a lower tax bracket.
The theory behind using traditional accounts goes like this:
Contributing to a traditional account during your working years gives you a nice tax deduction now, while you’re in a higher tax bracket (let’s say the 22% bracket). Plus, when you take distributions in retirement, you’ll likely be in a lower tax bracket (maybe the 12% bracket). In short, you’ll pay less in taxes!
If it always worked like that, it would be great. But what we find in working with federal employees is that when you add a retiree’s Federal pension to their Social Security benefit, and perhaps a spousal Social Security check on top of that, many find themselves in the same tax bracket they were in during their working years. There’s not a dramatic drop in taxable income.
This happens for lots of reasons. Many of the deductions you were able to claim throughout your working career disappear. You’re no longer contributing to a TSP or IRA and getting that deduction. Your federal health care is no longer tax deductible. Your children have grown up and moved out so you don’t get that deduction. Losing all these deductions means your taxable income will be higher!
Many are frustrated because they don’t need to take distributions from their TSP. But at age 73, or 75, they are forced to do so. And that extra “taxable income” can sometimes kick them up into a higher tax bracket.
And if–going back to reason #1 above–tax rates have gone up, it’s a double whammy. You’re in a higher tax bracket, and the rates for that bracket have risen too!
So, what can we do about these potential problems? Is there a way to address them?
Yes. The short answer is to “go Roth” instead of the traditional route.
Would a Roth TSP or IRA help you avoid possible future tax increases? With Roth, you pay taxes now instead of later. So a tax increase in three years or 10 years or 20 years will not affect your Roth account.
What about mandatory distributions? Would a Roth account fix that? Yes. Because with Roth, there are no required minimum distributions during your lifetime. Your money can stay in your Roth account and continue to grow. During your lifetime, there are no forced withdrawals.
In addition, there are no mandatory distributions for your spouse even after your death. So, Roth addresses that issue as well. Your spouse can roll your Roth money into their personal Roth IRA and not have any RMDs.
I do need to point out that non-spousal beneficiaries are required to abide by the 10-year rule regarding distributions. However, those withdrawals are not taxable. So, that requirement doesn’t pose a tax problem.
A Roth account addresses one other problem–the risk of being bumped into a higher tax bracket. First, there are no RMDs with Roth. You are never required to take money from your Roth account. And, second, even if you do choose to take distributions, they won’t bump you up into a higher tax bracket, because Roth distributions are not taxable.
To recap: Having money in a traditional TSP (or IRA) can create certain problems. A Roth account can alleviate those problems.
So, let’s say you’re 60 years old, and the majority of your money is in a traditional TSP. Now you’re thinking Yikes! I don’t want to keep my finances like this. What can I do?
Good news!
- If you’re still working, you can start contributing to a Roth TSP.
- If you’re 59 and a half or over, you can move your TSP out into an IRA and begin doing Roth conversions.
- If you have retired or separated from service–no matter what age you are–you have access to your TSP and can roll it into an IRA and begin doing Roth conversions.
We have multiple videos on Roth conversions on our Christy Capital YouTube page. We believe that’s a wise strategy for many people. But can you mess it up? You can. So, be sure to check out this video, “Six Roth IRA Mistakes.”
Meanwhile, if you have questions about your traditional TSP or need help thinking through any other financial matters like these, visit our website, christycapital.com. There–in the top right corner of the page–you’ll see a green TALK WITH AN ADVISOR button. Click it, and leave us a short message. We’ll be in touch right away.
At Christy Capital Management, we help clients take the mystery out of retirement. We’d love to help you too.
