Federal retirement expert, Chris Kowalik, discusses how federal employees can leverage the Roth TSP to create tax-free income for themselves in retirement.
Key takeaways:
- The basics of Roth-styled accounts and what the ultimate objective is
- 7 critical considerations before getting started with the Roth TSP
- How the Roth TSP works while an employee is still working
- The tax consequences for the Roth TSP — and when they happen
- 2 major surprises when federal employees have a mixture of Traditional and Roth money invested in the TSP
- How the Roth strategy can be leveraged during retirement — both in and outside of Thrift Savings Plan
- The concept of tax diversification
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Scott: Hello, and welcome to this episode of Fed Impact, candid insights on your federal retirement. I am Scott Thompson with myfederalretirement.com, and I’m here today with Chris Kowalik, of ProFeds, home of the Federal Retirement Impact Workshop. In today’s episode, we’re going to focus on a specific component of the TSP, called the Roth TSP. Chris, it’s so great to have you here again today.
Chris: Gosh, thanks so much. Yeah, today’s episode on the Roth TSP I think will help bring some clarity to this relatively new program, and how it may be one of the most powerful choices that employees make while they’re still working that can drastically influence their income and even their taxes and retirement. So, the Roth TSP came into existence by way of the National Defense Authorization Act of 2010, but it didn’t come out for a couple years. It was officially rolled out by most agencies in 2012. So, throughout this episode, we’ll be talking about some medium level concepts in the Thrift Savings Plan. We’re kind of going on the premise that our listeners today have a basic understanding of TSP. For listeners who are relatively new to the TSP, I would suggest pausing this episode and listening to our episode on the TSP basics. So, for everyone else who’s already familiar with TSP, we have a ton to share with you today on the Roth option.
Chris: It is. We always get tons of interest on the Roth, and what everyone wants to know, exactly what you said, is should I do it? Is it the best thing for me? So, there’s so much to consider, and of course, everyone’s situation is unique, so while I can’t tell every one of our listeners today that the Roth is for them, I can tell everyone how it works so they can begin considering if it makes sense to at least put this thought in your mind of the Roth, and does that make sense as part of a larger retirement investment strategy.
Scott: Okay. Well, this seems like a pretty big topic, Chris. How should we break this down for our audience today?
Chris: Yeah, I see the discussion about the Roth TSP logically breaking into three main categories. The first is the basics of Roth-styled accounts, and what the ultimate objective is, as opposed to traditional-styled accounts. The second is how the Roth TSP works while an employee is still working, and then next, how the Roth strategy can be leveraged in retirement, both in and outside of the TSP. And I don’t want to forget, we’re also looking for feedback on all of this material, so we’ll tell our listeners more about that near the end of today’s episode.
Scott: Okay, well it sounds like we’ve got a lot to cover today, so let’s get started getting a good understanding of how the Roth accounts work.
Chris: Yeah, so let’s begin with a program that most of our listeners have been familiar with for a long time, and that’s the traditional TSP. It’s been around since the mid-80s, when TSP began. We all know that from a tax standpoint that when an employee contributes to the traditional TSP, they don’t pay tax now, because it’s tax deferred, and it’s going to be deferred until such time that the employee begins to take money out of the account in retirement. So, with the traditional account the tax benefit is upfront when the money goes in, and taxes are paid later. With a Roth TSP, taxes work exactly the opposite, so in many ways, the Roth TSP is similar to a Roth IRA that you’d find out in the private sector. So, an employee contributes to the Roth TSP, bites the bullet, pays the tax now, and then when they go to take the money out in retirement, all of the money that they get is tax-free.
So, there is a tax advantage to both the traditional and the Roth, it’s just a matter of when you capitalize on that, either now or later. Now, here’s something that I think often gets overlooked with respect to the traditional and the Roth. The principal in this case is the employee’s contribution, of course, and the difference between these two options is whether you pay tax on the earnings. So, you’re always going to pay tax on the principal, it’s a matter of if you want to pay tax on the earnings. With the traditional TSP, you’ll pay tax on the earnings, you just do it later in retirement when you take the money out. But with a Roth TSP, as long as you meet some very basic requirements by the IRS, you never pay tax on the earnings. That’s the beauty of that type of account, and this can mean a huge difference in retirement.
For so many folks that are trying to think about what the difference would be if they were to put money in the traditional versus the Roth, and all of that. There’s a handy tool on the TSP website, and it helps see what the tax consequences are for doing each type of account in any mixture that you choose, so it shows what your paycheck will be based on the contributions that you make to the traditional and the Roth sides of the account. So, for all of our listeners today, we’ve put a link at the bottom of this webpage for all of you who are listening from the myfederalretirement.com website, so just below the play button are the links to some of these helpful resources.
Scott: Okay, now you mentioned that the Roth TSP is similar in a lot of ways to the private Roth IRA. Could you expand on this point a bit more, and describe the differences?
Chris: Oh, of course. So, with the Roth IRA, again, a private sector account, from a tax standpoint, it works exactly like we described for the Roth TSP. You put the money in now, you bite the bullet, pay the tax today, and then when you take the money out, it’s all tax-free. So, of course the people who benefit most from this type of strategy are the people who have this account for a relatively long period of time, because presumably, there’s more growth, the longer we’ve had an investment in place. Now, someone who’s funded a Roth account for 30 years of course has a much better opportunity to have a larger gain than someone who’s only held the account for five years. So, the longer you’ve held this, the larger the opportunity that the growth has risen in the account, and that’s really where the huge tax advantage is with the Roth.
Now, the difference with the Roth IRA is that a person must meet some certain income requirements or criteria to be eligible to contribute to get a chance at this tax advantage. So, for a single person, the most that they can earn is 132,000 a year, and for a married couple, that limit is about 194,000. So, anybody above these income levels, they’re simply ineligible to contribute on the private side and reap the tax advantage. In fact, if they do fall under these limits, the most that they contribute to the Roth IRA per person is 5,500 per year. Now, it’s 6,500 if they’re at least 50, but there are limits. The first limit is how much you can make to be eligible to contribute, and then assuming that you do qualify for that, the most you can put in is either 5,500 or 6,500, depending on your age.
Now, put that into contrast to the Roth TSP. It does not matter how much a single person or a married couple make. They can contribute either 18 or 24,000 if they’re at least 50, and this is tremendous. Such an opportunity for federal workers, especially for employees who wouldn’t qualify for this program in the private sector through a Roth IRA. Huge. Now, of course, the IRS puts a few caveats on both the Roth TSP and the Roth IRA, so there are two big ones. They’re pretty easy to meet, but we want to make sure everybody’s clear on this.
The first is a person must be at least 59 and a half before taking money out of these accounts, and there are very minor exceptions. SO, 59 and a half is the target age. The IRS does not want anybody taking their money out before that point. The other requirement is that from the time the account is first funded, five years must have passed from that point before withdrawals are taken. So, if we have somebody about ready to step into retirement, it becomes harder to reap the advantages of the Roth TSP because we’ve got the leave that account alone for five years. So, it just adds a little bit of a layer of complexity on that.
Now, of course, we’ve got to try to figure out what that right balance is for everybody. We all like the idea of getting immediate tax benefits, but we’re wondering, really, how to balance those with future tax benefits.
Scott: Yeah, I suspect that might be a balance that’s hard for employees to strike, deciding when to get the tax benefit.
Chris: Right, right. Yeah, you got it, it’s a real struggle for so many people, because they’re not really sure how their tax situation is going to change in retirement. So, after all, because we’re not sure if the tax environment will be higher or lower, because, of course, taxes change all the time, it causes us to not be sure which tax bracket we might find ourselves in when we’re in retirement. So, let’s dig into these two concepts just a little bit, and this is always an interesting conversation in our retirement workshops. The first question I would ask is are taxes going to go up or down? And the answer is yes. They’re going to go up and they’re going to go down. I mean, they always feel like they go up, right, they never feel like they go down. But if we look historically behind us, we know that taxes rise and fall all the time, and so when we think about if taxes are going to be worse in the future, it’s all relative. Up or down from where? From what level?
So, we’ve got to recognize that taxes do fluctuate over time, and it’s not just up. The next question is, am I going to be in a lower tax bracket once I retire? We all hope that we would be, but this one’s a little bit trickier, because most people would make the assumption that they will be in a lower tax bracket when they take a big pay cut going from drawing, of course, a full-time salary to a pension and retirement. You figure, “Gosh, well, I’m making less. Shouldn’t I be in a lower tax bracket?” If that was the end of the story, then that would make this conversation really easy, but it’s not, because here’s the challenge: people take a step down from drawing their full salary, to drawing their pension from SRS or FERS, and that money is … The vast majority of that money is taxable. Then the gap that they have in their income of the drop that they had in pay, employees fill it from two buckets of money. That’s Social Security and TSP, and those are taxable too.
So, if you end up coming right back up to the same income level because you have perhaps the same expenses. Maybe expenses are even higher for some folks in retirement, based on the choices that they’re making. Then the challenge is, “Well, gosh, I’m right back up into the same tax bracket that I was right before I retired. How is this even possible?” It’s crazy. So, yeah, with respect to this giant income gap with taxable money, and then figuring out what tax bracket you’re going to be in, we have to really recognize that we might very well be right back in that same tax bracket that we were right before we retired.
Scott: Yeah, and I can see that might come as a big shock to so many today who have generally thought they’d be in a lower tax bracket once they retired.
Chris: Exactly, and unfortunately we get that reaction a lot. Really, our only saving grace in all of this is that we know we might be in a higher tax bracket in retirement, so that we can start to do something about it today. So, I want to introduce a concept that our listeners may be somewhat familiar with, and it’s called tax diversification. Tax diversification, this is the idea that in retirement, that we don’t want all of our money taxed exactly the same way. So, ideally, we have different buckets that we can take money out of, and they all have different tax results so that as taxes fluctuate either up or down, we’re able to pick and choose which bucket to take the money out of in retirement. So, when taxes are relatively high, we would prefer to take the money out of a bucket that we don’t have to pay any tax on, like a Roth TSP, like we mentioned before, because you don’t pay tax when you take the money out.
Conversely, of course, when taxes are relatively low, we don’t mind paying up and making good on our tax debts, so to speak. So, of course, if all we have to pull from is taxable money, then we’re stuck with whatever tax situation we may find ourselves in, either good or bad. So, I like to tell folks that with a Roth TSP, this is a way to create tax-free money on purpose and make sure that you don’t end up in a situation where you’re stuck with whatever the tax situation really is at that time.
Scott: Right. Well, that’s an interesting strategy, and it’s one I bet our listeners are eager to hear about how they can get started. Can you share a bit more how an employee would get started with the Roth TSP, and more about how the program works while a federal employee is still working.
Chris: Yes. So, quite a few things I think an employee needs to know about the Roth TSP before they get started. The first is the most money that an employee can contribute to the TSP total is 18,000, or 24,000 if they’re at least 50 years old, and I stress the total part. We cannot say, “I want to put 24,000 Roth, 24,000 traditional.” I would completely high-five an employee for being able to save 48,000 per year, but that is not allowed in TSP. So, whatever combination that they want between the Roth and traditional is fine, but they can’t exceed either that 18 or 24,000, depending on their age.
The second thing that I would share with employees before they jump into the Roth is that existing money in the TSP, so that’s all the money that has already been put there, can’t be made Roth. So, if you’ve got $300,000 in your TSP on the traditional side, you can’t say, “Well, I want to make half of that Roth,” at that time, okay. In the private sector this is allowed, and we call this a Roth conversion, but they are not allowed in the Thrift Savings Plan. So, the only way to get Roth money into the TSP account is to make an election to make Roth contributions from now forward. New money, we call it.
The third consideration or thing I want feds to think about before they jump into the Roth is if a FERS employee decides to put all of their contributions to the Roth side of their account, they make a drastic swing to the other side, they’re still going to receive all of their matching money, but that money is going to be deposited on the traditional side of their account. After all, of course, the agency doesn’t want to satisfy the tax on that money that’s going in, which they would have to do if they contributed it to the Roth side. So, to be clear, employees are not missing out on any matching money by contributing to the Roth, it’s just going to go to the traditional side of their account.
The fourth consideration that I would have employees really take under advisement is that an employee must decide what percentage of their contribution will go traditional, and what percentage will go Roth. Any percentage split is okay with TSP. An employee could go 100% traditional, or 100% Roth, or anywhere in between. This selection only tells TSP which tax bucket it goes it, which tag that money’s supposed to have. Is it taxable, or is it tax-free?
The fifth thing I would encourage employees to really think about is if an employee were to be putting away 18,000 into the traditional TSP, and then one day decide they’re going to switch it all to Roth TSP contributions, they will most certainly feel the tax impact. Come April, they don’t have the tax deferral anymore, so now they may be have 18 or 24,000 of income that they’re going to have to claim for taxes in the current year. So, in the long run, it may still be very worth it to make this change, but nobody wants to be surprised or left owing the IRS money in April, or really, even, to be shocked when they see their paycheck, because it’s going to take a whole lot more money to put the same amount of money in the Roth, because you have to pay tax in that pay period as well.
The next consideration is traditional and Roth TSP monies, all of that new money going in. They are invested in the exact same funds in the Thrift Savings Plan, so of course we’ve got the G, F, C, S and I funds. Those are probably not new for any of our listeners, but I want to give an example. So, I’ll first start with the example of what employees cannot do. They cannot tell the TSP to direct their traditional money, say, to the G fund, and the Roth money to the S fund. It doesn’t work that way. They have to pick the allocation between the G, F, C, S and I, an the money that is going into the traditional or the Roth, or any combination, it’s going to go exactly that way.
So, you set your contribution allocation. Again, that is the funds that you want to invest in and in what percentages. The TSP directs all of your money, regardless of how it’s taxed, to those specific funds in the percentages that you’ve chosen. That’s a major misconception I hear in workshops all the time, because people think, “Well, gosh, if I’ve got different type of taxable buckets, maybe I’ll let one ride and be a little bit more volatile, but I’ll keep the other one safe. It does not work like that. So, employees who wish to begin contributing to the Roth TSP, they can either complete the TSP one, the election form, or they can of course log into their TSP account to make the change. So, if after this podcast they decide they want to be looking at the Roth, those are the ways that they would update their accounts to reflect that.
Scott: Okay, well, that’s a great deal of clarification on this topic, and I bet it helps employees to get a grasp on how the Roth TSP works while they’re employed.
Chris: Yeah, I hope so. See, oftentimes when there are complex rules or concepts that we’re considering on any topic, whether it’s investing or anything else, it’s just easier to do nothing, and we both know that to take advantage of various planning strategies, we have to take action. So, it’s not just enough to know about it, we actually have to do something. So, hopefully this helps.
Scott: Yeah, you’re right. The Roth TSP seems like a good strategy that would help a lot of people, but they must act to be able to take advantage of those tax benefits. Since we know the real tax advantage of the Roth happens in retirement when someone actually is pulling the money out, would you mind touching on how things work once an employee retires and begins withdrawing money out of the TSP?
Chris: Yes. So, this is the third and kind of final phase of our episode today. We talked about kind of the general rules of the Roth, how the Roth works while someone’s still working, and then now we’re transitioning to that retirement phase. So, in some ways, we’re going to find that the Roth TSP works very similar to its counterpart in the private sector, that Roth IRA. In some other very important ways, it will operate substantially different, so as you might expect, many of these things are interconnected, so as I’m describing how the Roth TSP works in retirement, I’ll be sure to point out how it’s different than the private sector Roth IRA.
Scott: Okay, well, that sounds great. Where should we start?
Chris: Perfect, so let’s circle back to the original purpose of why we have different accounts that have different tax implications, that concept called tax diversification. Remember, when taxes are relatively high, we want to pull the money from a tax-free account, and when taxes are relatively low, we want to pull money out of the taxable account. Keep it in mind that the more your account grows in a traditional account, the more taxes you owe on it, right, because it’s just going to be a percentage of everything that you pull. So, there are two major ways that the TSP may offer up some surprises when employees have a mixture of traditional and Roth money in the TSP. The first is, when you take withdrawals out of the TSP in retirement, you cannot direct them to only give you traditional money or only give you Roth money.
Yeah, so in the TSP, you must take withdrawals across the entire account. For an example, if 90% of your account is traditional, and 10% is Roth, then if you take 100 bucks out of TSP, you have to take 90 from the traditional side, and 10 from the Roth. So, by and large, it defeats the main reason to have two different types of accounts from a tax standpoint, which is really the ability to pick and choose which type of taxation you want at any given time in retirement. So, in an employee wants that type of tax flexibility, then they’re going to need to move their money out to two private IRAs. One will be a traditional TSP that will come out to a traditional IRA. The other, of course, the Roth TSP comes to a Roth IRA. Then there they can direct these private accounts to distribute the way that they need it, so when taxes are high, they pull it from the Roth, and vice versa when taxes are low.
So, that is the only true way to have tax diversification with this bucket of money. I’m not exactly sure why TSP decided to do it that way. They set employees up at the beginning to have a really great advantage by having the ability to contribute to the Roth, but then they kind of fumbled the ball a little bit on the other side by not allowing them to take it in the way that those types of accounts were intended. Crazy.
The second way that TSP might surprise some employees is out in the private sector, if a person has money in a traditional IRA, which is taxed the same way as a traditional TSP, around the age of 70 and a half, they are required to take a percentage of money from their account, and that percentage is determined by the IRS. Many of our listeners have probably heard of required minimum distributions, or RMDs. While RMDs are required on traditional IRAs in the private sector, they’re not required on Roth IRAs. Okay, so let’s get that straight of how that works. On the private side, only traditional accounts like traditional IRAs are required if folks are required to take those minimum distributions that the IRS determines. That’s not required on a Roth IRA.
So, this is another reason that Roth IRAs are so attractive in the private sector, because you’re not required to ever take anything out of it, which allows you to maintain a larger amount well into retirement when you feel you might need it, and it allows you to pass money to another generation tax free. Here’s the catch: RMDs in the Thrift Savings Plan are required on the entire account. Not just the traditional side of the account, but the Roth side of the account as well. So, even though RMDs are not required in the private sector for Roth accounts, they are required on the Roth TSP. Big surprise, big surprise.
So, if an employee only wants to be required to take money from the traditional side, then again, they must move their money out to the private sector, traditional TSP comes to traditional IRA, Roth TSP to Roth IRA, and then the RMD must only be satisfied on the traditional IRA from that point. So, this lessens the blow that comes with being forced to draw down an account, especially if you don’t need it. That’s the real challenge.
Scott: Yeah. Well, it sounds like there’s some really great parts of the Roth TSP while working, and then things change considerably in retirement. Do you have any parting words for our listeners today on this?
Chris: Yeah, what you just said was spot on, Scott. There are good and bad parts to every possible product that exists, whether it’s a government benefit or a private sector product. The key with any type of long-term investment strategy is knowing how to take advantage or leveraging all of our options with a mixture of different strategies. So, in this case, some of those strategies might come from the Roth TSP, like being able to amass a lot of wealth in there very quickly that you can’t really do out in the private sector. And some of the advantage is the strategy might come from a Roth IRA. Again, being able to utilize the money more strategically in retirement, depending on the different tax situations.
So, my parting words of advice are don’t be afraid to look at all of your possible solutions out there, and don’t have a misplaced loyalty to a program simply because it’s offered by the government. No employer-sponsored plan could possibly have the perfect solution for millions of employees and retirees. Every one of our listeners deserves to do the right thing for their circumstances and their families.
Scott: Yes, okay. Well, those are powerful words that I hope our listeners will really take heart with as they’re figuring out their own retirement strategies. Chris, as always, you are so generous with this information. I really appreciate you providing this to our listeners today, it’s really good. Now, you mentioned that you enjoy getting feedback from employees, and you want to encourage the listeners to interact with you. What kind of feedback are you looking for, and where should employees visit to give you that feedback?
Chris: Yeah, I’m so grateful to be able to provide this information for our listeners today, and glad to be able to bring everybody up to speed on this great opportunity on the Roth TSP, and really how it works in retirement. As for feedback, if our listeners have ideas on topics, or just want to share their reaction to today’s content, they can certainly visit us at fedimpact.com/feedback. We’ve put that link right at the bottom of this page on myfederalretirement.com, and hopefully employees will visit there and share their thoughts.
Scott: Well, great. It’s been great to have Chris Kowalik of ProFeds with us again today. I’d like to invite you to stay tuned for the next Fed Impact podcast to get straight answers and candid insights on your federal retirement.
