Delivered on: Thursday, March 21, 2024

To watch on YouTube, CLICK HERE

Tackling the Tax Train

Exploring the Roth conversion strategy to drastically reduce your tax obligation in retirement:

• ISSUE: Taxes have been deferred for many years, but will be payable in retirement
• EFFECT: Higher taxable income in retirement affects other benefits like Medicare
• CONCEPT: Create a strategy to begin to make your TSP account tax-free in retirement
• COMPLEXITY: What to watch out for to ensure you implement this strategy correctly

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Prefer to read instead? A transcript of this webinar is below:

Hello and welcome everybody to the FedImpact webinar on “Tackling the Tax Train with the Roth Conversion Strategy.” This session is coming straight out of our workshops and the questions that we get there from federal employees who are trying to gain a tax advantage in retirement and they’re not really sure how to do it. We’re going to be covering those specifics today.

You guys know me, I’m Chris Kowalik, the founder of ProFeds the developer of the FedImpact Retirement Workshop, our flagship program (that’s out there educating federal employees on their benefits), and I am the host of the FedImpact podcast. I have lots of different ways that I am able to get good information out to federal employees, and we’re delighted to be able to do this session for you today.

Tackling the tax train today, we’re going to be talking about exploring this idea of the Roth conversion strategy so that you have an opportunity to drastically reduce your tax obligation in retirement. After all, you look for those opportunities while you’re still working to get a tax advantage. Why not also look in retirement to see what that looks like?

Agenda

For our agenda today, we’re going to talk about the real issue, which is you have a big bucket of money that you have chosen to defer paying taxes on for many years. You’ve been saving all of this time perhaps in the Traditional TSP, and eventually that money’s going to be taxable, and we have to figure out how we’re going to manage that reality in retirement.

Next up is effect, so that higher taxable income in retirement where you’re taking money from a Traditional account and owe taxes on it might very well affect other benefits like Medicare. Now, who would’ve thought that taking money out of TSP would affect how much you pay for Medicare? That is an unknown thing for a lot of people, and we want to kind of clear the air there on how that works.

Next is the concept. This concept of the Roth conversion strategy. We’re able to make those TSP monies that you have in the Traditional side, how do we begin to make those tax-free for you in retirement? And then next we’re really going to have an underpinning of all of this, which is complex, right? The tax code in and of itself is complex, but there are some specific things to watch out for to ensure that when you’re implementing this strategy that you do it correctly.

We’re not going to follow this agenda in order. These are simply the types of things that we’re going to be covering in today’s session, kind of sprinkled throughout a lot of the questions that we typically get about Roth conversions and this idea of how do we avoid this big tax problem in retirement.

What this webinar will NOT cover

This is a little bit of a loaded webinar. There is a lot to cover here. I’ll be honest, when I was designing this webinar, there are a lot of different ways we can design material, and I wanted this to be as straightforward and helpful to you as possible, but there are a couple of things that I need you to understand.
The first is the intention of this webinar is not to give you tax advice. My intention is to give you some tax awareness. I want you to appreciate that you have maybe more control than you think. You just have to be willing to play the tax game.

We’re not suggesting that the Roth conversion strategy is appropriate for you. We have thousands of you guys on these sessions, so how on earth could we possibly tell you all that a Roth conversion is exactly what you should do.
What we are suggesting for each and every one of you is that you have a meaningful conversation about the kind of control that you can have over your tax situation so that you can put yourself in an advantageous position. We don’t want taxes just to happen to you. We can have a little bit more control than we think.

Lastly, as far as what this session does not cover, this is not an exhaustive reference of the Roth conversion strategy. This stuff is super complex. I would probably bore you with the details, but of course the devil’s always in the details and so I’m going to bring as much to light as I can knowing that you have to seek professional advice for your unique situation.

That’s not just to protect us in the delivery of this material, but really to protect you. You don’t want to try to do this on your own. I caution anyone thinking that this is simple enough to be able to go out and execute in a really easy way. I implore you please get some professional advice. We’ll talk a little bit more about that in today’s session, but definitely a lot to cover today.

The Tax Situation Room

Let’s talk about the tax situation room. I don’t know if y’all are actually doing your own taxes these days, but if you’re like me, I look at this tax code and I’m like, good grief, this thing is so complicated and then it changes with different administrations and things expire and things start and it can be really overwhelming. But here’s what I want you to know. There’s actually a couple of things, but let’s start with the most obvious thing, which is things aren’t always obvious, so we have to make predictions about taxes.

Some important questions

There are a couple of questions that I would ask of each of you. The first, do you think tax brackets will change in or out of your favor in the future? We’re going to talk about tax brackets here in a moment so that you can see how it’s broken out today. It will change of course, but do you think it’s going to change in or out of your favor?

The next question, will your tax obligation be higher or lower in the future? Now you might think, well, Chris, you just asked that question. You asked me about tax brackets, but tax brackets don’t tell the whole story. They’re part of the story of your tax obligation, but ultimately what you care about is not what tax bracket you’re in, but how much you owe. So do you think that’s going to get better or worse for you in the future?

Then last, how do your tax choices look in the future? You’re going to see today where you can start creating some choices for yourself based on actions you take before you actually need the money out of the TSP in retirement. We like to give ourselves as many choices as possible so that we can decide which is most advantageous to us and do that, right? We don’t want to only have one option because then that’s not really an option – that is simply being told what we have to do and we’re stuck. Nobody likes feeling stuck in retirement or being forced to take an action that they otherwise wish they could avoid.

Tax Brackets

Let’s talk about the first one, which are tax bracket. We currently have seven tax brackets in the United States. Here they are. Each one of those seven brackets have different filing statuses. Whether you’re single, married, filing joint, married filing separate and head of household, and each of them carry different advantages and disadvantages. It just depends what the situation is. But there’s a couple of things that I want everybody on this call to know.

On the far right hand side, you see us reference the “Tax Cuts and Jobs Act.” This current tax environment that we are in right now will sunset, meaning it will revert back to its previous status on December 31st, 2025.

What this means is that barring any action that is taken by the administration, this will cause more of your income to be taxed at a higher rate than it is right now.

We are historically at a low tax environment because of this particular “Tax Cuts and Jobs Act” that was enacted many years ago. It was just set to sunset to go away and revert back to its previous look a long time ago. That deadline is coming up at the end of next year. We need to appreciate that again, barring any change to that, that we are set to have higher taxes beginning in 2026.

Current tax brackets & marginal tax rates

Let’s talk about these brackets. This is this current tax bracket environment for 2024. These would be taxes that are due in 2025. In April of 2025, you’re going to file your taxes for the previous year of course, and this is really the tax situation that we are dealing with.

Based on how you file single married filing jointly, etc, you can simply go down that list and identify, well, where does your income fall? If you’re single? Of course you’re only looking at your income. If you’re married, you’re looking at both of your incomes and so you’re going to be figuring out where you fit in here and you look to the far left hand side and that is your marginal tax rate.
Now, I want to be clear that we have a progressive tax system, meaning that just because you might find yourself in the 24% tax bracket doesn’t mean that all of your money, all of your income is taxed at 24%.

In this case, let’s say you’re a single person, the first $11,600 of your income will be taxed at 10%. The next, from that point up to $47,150 is taxed at 12% from the $47,151 up to a little over a hundred thousand ($100,525), it’s going to be taxed at 22%.

When we think of your “marginal tax bracket,” that is, if you think of the last dollar that you earn, what is that taxed at? That would be your marginal tax bracket that we’re seeing here on the screen. Just know it doesn’t mean it’s your effective tax rate, which is the average of the amount of tax that you are paying. We just want to get some of the language right? We’re not going to get super specific in this today, but I do want you to appreciate that not all of your income is taxed at this rate that you see on the left hand side.

I chose to include these tax brackets. Again, not because we’re going to dive super deep into these numbers, because everyone’s situation is going to be a little bit different, but because I know that we are going to get questions about tax brackets and it’s simply easier to show it to you right here so that you have it in your handouts and can reference it easily.

Tax Obligations

Let’s talk about tax obligations. That was one of the questions that I asked you. Do you think your tax obligation is going to get better or worse in retirement?

Most people, when we ask federal employees in our retirement workshops, how many of you think you’re going to be in a lower tax bracket in retirement? The vast majority of the room raises their hand and it stands to reason because you think, well, I’m no longer getting my full paycheck. I’m going to take a pay cut and get my retirement check (my pension), and so of course I’m going to be in a lower tax bracket or at least have a lower tax obligation because I have less income.

That all makes perfect sense, but we have to Paul Harvey this. What’s the rest of the story? The rest of the story is that if you intend to maintain your standard of living (meaning, you need as much income flowing into your household, into your checking account so that you can still pay for all the things that you wish to do in retirement).

If you want to maintain that standard of living, but all of the assets that you have to pull from are taxable, like from your Traditional TSP, you are likely going to be back in the same bracket and have the same tax obligation or pretty darn close to what you had before you retired.

Off to the right hand side, you can see we’ve got that purple bar there. That’s your working pay. And you’re right, when you go into retirement, you no longer have that paycheck, you’re going to have your pension. But then we have Social Security on top of that, assuming that you’re choosing to draw Social Security. You might have the FERS Supplement if you happen to be retiring prior to 62, so that’s certainly an option. Then we have the Traditional TSP.

So if all of the money that we have is taxable, which all of this is Traditional TSP, Social Security, Pensions, those are all going to be taxable, at least at the federal level. Then you have now found yourself back paying the same amount of taxes that you did while you were still working. We have to understand how the tax obligation piece really works. The question then becomes is there any way to affect the taxability of the money that I’m taking as income, not from a paycheck, but income from a bucket that we’ve been saving for a long time? Can I make any of that tax-free? That’s really the question that we’re answering today.

How can you be in a lower tax bracket?

How can you actually be in a lower tax bracket? Is it possible? Yeah, there are two reasons that someone can end up in a lower tax bracket. One of them is really great and one of them is really bad.

We’ll start with the bad one first. If you have less money, you have less income flowing into your household to pay for your life, you’re naturally going to pay less tax. But who wants that? Who wants a lower standard of living in retirement? You probably have lots of things that you’ve been waiting to do from the time that you’re working, to stepping into retirement. You now need the income to be able to do that. So that’s the bad reason to end up in a lower tax bracket.

The amazing reason to end up in a lower tax bracket is that you have taken steps now to give yourself access to that money that’s in your TSP that is not taxed when you receive it later.

In order to do this, this takes a concerted effort. We talk about taxes a lot in all of the work that we do because taxes are a harsh reality of retirement. But there is an actual strategy to be able to do this.

Why your CPA might be the wrong person to ask

And I want to talk a little bit about why your CPA or your tax preparer might be the wrong person to ask. Your CPA or whomever is preparing your taxes each year if you get some help, they are judged by you based on how big the check is that they make you write to the IRS that year. It’s not their fault, but you connect their value and whether you like working with them with how big that check is that you have to write. That’s maybe unfair for CPAs or tax professionals, but that’s just the reality.

If your CPA hand you a huge tax bill, they may very well try to get you to minimize today’s tax because they’re afraid that that’s how they’re being judged. And they’re very fairly worried about that because that is unfortunately how we judge CPAs and really any tax professional, I kind of use that term generally here.

When we’re really looking at the bigger tax picture, we want to not be looking with blinders on, like looking at this year’s tax situation through two straws. We want to look at the big picture and say, what are we doing? Are we setting ourselves up for? And that becomes a really big piece of what we have to figure out, and the sooner we do it, the better.

Tax-advantaged vehicles

I want to talk about some of these tax advantaged vehicles that are available to you and we’ll talk about what’s available to you, specifically what’s available out in the private sector so that you can have some appreciation for how the tax code is really working and what those vehicles are that you could utilize.
Private sector accounts

I want to start with the private sector. We’ve all heard of IRAs, so these are individual retirement arrangements. These IRA options are available out in the private sector and they’re completely different than your TSP. They’re similar in many ways, but they’re quite different in the eyes of the IRS. Let’s talk about each one of them.

Traditional IRA

We’re going to start with the Traditional IRA. I know we have a lot going on on this slide, but follow along with me down that middle column. For a Traditional IRA, you are allowed to put in $7,000 per year if you’re under age 50 or $8,000. If you’re 50 or above. It does not matter how much income you make, you are still allowed to contribute to a Traditional IRA. And the beauty of it is that you’re not taxed now when the money is going into the account. You contribute with money that you have not paid tax on yet, and you’re choosing to defer that tax bill until later.

When the money comes out to you later, all of the principal that is all the money you put into the account and all of the earnings on that money is going to be taxed to you as ordinary income. Now, most people don’t take all of their account out at one time, they take it out over many, many years – and so that tax obligation is spread out, but it’s still there.

Now, there are some restrictions. Generally you must be at least 59 1/2 for the IRS to allow you to take out withdrawals from your IRA and have those be penalty-free. You can still access your IRA, but if you have to pay a penalty to get access to your money, that’s no bueno. So 59 1/2 is really the target age that the IRS has set for these specific accounts. That’s the Traditional IRA.

Roth IRA

Over on the right hand side we have the Roth IRA, and you’ll see the rule that they share is how much you can contribute to them. So $7,000 a year if you’re under 50 or $8,000 a year if you’re 50 or above.

But now we have some income limits. Essentially Congress (in the way they created the rules around the Roth IRA and what we’re going to be allowable in this program they said this is not intended for people who make “too much” money. For a single person, that limit is $161,000. If you make more than that, you cannot contribute directly to a Roth IRA.

There are some other ways you can get in it, and we’re going to talk about one of those ways today, but to just simply take your $7,000 or your $8,000 and contribute it directly to a Roth IRA in the private sector, that’s not going to be allowed if you exceed this kind of income.

And same thing on the married filing joint. We’re looking at $240,000 together. Now with the Roth IRA, you are going to be taxed in that year in which you contribute the money. You have already claimed that money as taxable income for that tax year, and so you’re just going to bite the bullet and pay the tax. The good news is it’s going to be tax-free later. All the principal, (that’s the money you put in) and all of the earnings on it are paid to you tax-free.

We have to decide when we’re willing to pay the tax now or later, and there’s certainly advantages and disadvantages to both. Now on the Roth IRA side, there’s kind of two rules. Generally you must be at least 59 1/2 to take those withdrawals penalty free, and you also must satisfy this five year holding period, meaning you have to have the account for five years to be able to draw that income tax-free.

Now, I’m way oversimplifying this, but these are the general rules. You can go to irs.gov if you want to see a lot of these exceptions and get into some of the nitty gritty. But I want to kind of get the high level overview here. These are the private sector options as far as tax advantaged vehicles that we’re going to talk about today. There are others, but these are the big ones that are out there.

Thrift Savings Plan Tax Options

Now I want to talk about the Thrift Savings Plan options. Of course, these are the ones that you’re used to. Let’s kind of dissect some of this.
Traditional TSP

You’ll notice for the Traditional TSP, you are allowed to put in a whole lot more than you could in a Traditional IRA. You can put in $23,000 a year if you’re under 50 or $30,500 if you’re 50 or above. That is a huge amount, way different than the IRA rules. And as far as income limits, it doesn’t matter how much income you make really on either side, Traditional or Roth.

Now in the last three ways, they’re very, very similar to what we see out in the IRA world. On the Traditional TSP side, you’re not taxed. Now you’re going to be taxed later when that money comes out, and generally you must be 59 1/2. We’ll talk about some special rules on the next slide, so hold that thought. I’m sure that’s rolling around in your head.

Roth TSP

But on the Roth side, same as the Roth IRA, you are taxed now on the income that you put into a Roth TSP, but you know that it’s going to be tax-free later. And the same kind of rule applies. Generally you need to be 59 1/2 and satisfy that five year holding period for a Roth TSP.

Penalty-free access to TSP

Let’s take a little bit of a look at some of the details here. Like I mentioned on the previous slide, there are some special exceptions for federal employees that I want to lay out here. In order to get penalty free access to TSP, we have to make sure that we’re following a couple of rules. And these rules are lightened for you. They’re not quite as heavy as they are out in the private world.

Exception for federal employees to avoid the early-withdrawal penalty
For federal employees who are either retiring or separating from federal service, you can access your TSP funds without penalty as long as you meet these rules.

Regular employees

If you are a regular employee, (so not a law enforcement officer, firefighter or air traffic controller), if you are a regular employee as long as you retire or separate in the calendar year in which you turn 55 or older, you are allowed to access your TSP account without penalty. You still have to pay the tax on it if it’s Traditional money, but you don’t have any penalty.

Law Enforcement, Firefighters & Air Traffic Controllers

A similar rule applies for those special category employees that I mentioned before, law enforcement officers, air traffic controllers, firefighters, as long as they either retire or separate in the calendar year in which they turn 50 or older, or if they qualify for one of those special retirements regardless of their age, as long as they have 25 years of that special service, they are able to access this account as well.

These folks are required to retire much earlier than the average person. Of course, normal regular employees don’t have a mandatory retirement age, and so we see people working pretty late in life in the federal government, but law enforcement, air traffic controllers, firefighters have mandatory retirement so that they’re not too old to be in those positions. That’s just a special rule. And so they’ve given them some unique access to the TSP through this rule. These are the rules that you have to follow if you want penalty free access to TSP.

A visual look at the TSP: Traditional

I want to get some visuals to this. It’s one thing to hear about it, it’s another thing to see it and maybe appreciate it a little bit more. Here we’ve illustrated the Traditional TSP and I want to show you where the tax advantage is happening and where the tax disadvantage is happening.

Starting on the left hand side, when the money goes into the TSP, you’re going to save tax today on the principal because remember, you don’t claim that as income. It’s deductible to you — it is never reported as income. That principal that we see in the blue box, when that same money that you put into the account comes out to you in retirement, it’s going to be fully taxable when you choose to take it out.

Again, most people don’t take out the whole account at one time, they take it out over many years, and when you do, it’s going to be fully taxable to you. And I think everyone can probably appreciate that part of the Traditional account. Like, yeah, I’m saving taxes today, but I’ll pay them later. No big deal. But what I think a lot of people don’t fully appreciate is that it’s the growth on that money that we’re worried about because all of that growth is fully taxable too.

Most of you, if you look at your TSP statements, if you’ve been contributing for a long while, the majority of the money that is in your account is not money you put there. It’s matching money and it’s growth on your whole account and right, that’s the idea. We’re not just putting money in the mattress to take it out later, we want it to grow. The more it’s grown, the more taxable income you are going to be responsible for when you take the money out.

This makes the Traditional side of TSP maybe a little less exciting when you realize that you kind of kick the can down the road a bit and now we have a big tax problem. This is the tax train. It’s coming for you. If you have a lot of money in the Traditional TSP, you’re going to be hit with this tax bill that you are likely not going to appreciate.

A visual look at the TSP: Roth

Let’s talk about the Roth side. The Roth doesn’t feel nearly as good when you put the money in because you have to go ahead and claim that as taxable income this year. That principal that you put in, you’ve claimed that as taxable income, but when that money comes out, it’s tax-free and all the growth on that money is tax-free too. There’s a lot that goes into deciding what you’re going to do with the different types of tax advantages. There legitimately are advantages and disadvantages on both sides.

Tax Diversification

Here’s the deal. In the financial planning world, this concept is known as tax diversification. The idea or the concept here is to have different buckets of money that you can choose from that are all taxed differently in retirement. We’re going to kind of narrow in on the Traditional and the Roth style accounts because that’s what we’re talking about today.

But in this strategy, you get to choose when and how to take the money from each one of those buckets, and you do that by looking at the tax environment that you happen to be in at that time. We don’t necessarily know whether taxes are going up or down, but we know they’re going to change over the duration of our lifetime.

They’re going to go up and they’re going to go down. We just don’t know when and for how long. The idea here is that when taxes are low, that we don’t maybe mind taking money from a taxable account like the Traditional TSP or Traditional IRA when we’re in a generally low tax environment. But when taxes are really high, that’s when people can turn to tax-free accounts like the Roth because then they don’t have to suffer the tax bill because that money is not taxable to them.

When we think of this tax diversification, this is a strategy that helps you to control your taxes. And when investors use strategies like this and the more tax diversified their portfolio is, the more flexibility that they end up having over their tax burden each year because they were able to pick and choose which bucket to take money from, they get to have more control over how much tax they owe that year.

Case Study / Example

We’re going to use a case study today. Now, normally in a case study, I’m getting way into the weeds on the numbers and how old they are and when they plan to retire and how much money they have and all of those pieces. I’m not going to do that today because I don’t want to confuse today’s session with the idea of what should I know about Roth conversions and the general concept versus the how to step-by-step guide to do it yourself.

It is far too complicated to do it this way. As far as me showing you exactly how to do a Roth conversion, because I am not licensed to be able to provide that advice to you, and I want to make sure that you’re having that real conversation with a pro that can help you walk you through that. But the natural question that we would have an employee like Linda ask us in a workshop is, okay, cool, I have money in the TSP and I like the whole thing, but before I knew about that, I had all this money in the Traditional TSP and my agency keeps contributing to the Traditional TSP with my match.

Linda says, “I have $300,000 in there in my Traditional TSP. How can I make that be tax-free in retirement?” How do I get out of the tax burden of that 300,000 later when I go to draw the money? That’s the question that we get some version of that in every workshop that we do. Somebody is asking if I want to change my mind on the way these things are taxed, can I do that and how? I want to walk through the basic concept here.

The General Concept of a Roth Conversion

The general concept of a Roth conversion is we’re going to start off on the left hand side, follow along, don’t jump ahead. We have the Traditional TSP, and again, let’s say that there’s $300,000 in there if you want to start to make this tax-free. The only way to do it is to transfer it to a Traditional IRA.

We’ll talk about the TSP rules here in a moment, but the TSP doesn’t allow this. What I’m going to show you to happen inside the TSP, so that $300,000 in the Traditional TSP would be transferred to a Traditional IRA. We’re essentially just putting a new label on this account, but $300,000 was in the Traditional TSP $300,000 is in the Traditional IRA.

Now we start to get to this conversion component here. The idea is that we take that Traditional IRA and we convert it to be a Roth IRA in the private sector. You’ll notice we still have $300,000 there.

Well, how is it that we still have $300,000 if we had to pay the taxes on it? Well, most of the time you want to pay these taxes with money from outside of your IRA or outside of your TSP. We’re talking about money that you have in savings, checking accounts, whatever that might look like to be able to pay the taxes on here. And here’s the deal. We’ll talk a little bit more about the breakdown of this in a moment. But at the time of the conversion, this is when taxes get paid and then never, ever again. That’s the beauty of the Roth. Once it’s in the Roth account, it grows tax-free.

If you were to take the money out of this $300,000 to help you pay the tax on the conversion, you’re now going to start with a lower dollar amount in this super duper account – this Roth IRA that amazingly doesn’t have any tax from that point forward.

You’re effectively minimizing the tax advantage that you really have, but it’s hard – who could roll over $300,000 and convert it all and pay tax on an additional $300,000 of income. Not only is that going to be a huge tax bill because you now have $300,000 more income, you’re naturally going to be in a higher tax bracket. This is going to be taxed at a higher rate when otherwise you’d prefer to avoid that.

There is a great strategy to be able to convert a little bit at a time so you don’t have to convert the whole $300,000 at one time. You could do that over the course of several years to spread out the tax burden. I just wanted to get the general concept here so that you understand the steps that have to happen, but we can break out some of these to minimize some of that tax obligation.

And there’s lots of different ways to look at this and slice and dice how much it is that you’re going to be paying in taxes. That should all be part of that conversation that you are having with a financial professional that knows how to do a Roth conversion and get you on your way.

Covering the Most Frequently Asked Questions

I really thought about how I was going to deliver all of this material today, and sometimes I have lots of slides with all the rules listed and then other times we do more of these FAQs and I thought I’d do the FAQ style here because I want to make this information as accessible and human as possible, and sometimes the rules don’t really lend themselves to that. I’m going to put these in the form of questions that we get when people are at our workshop and they’re asking those questions about the conversions and how they work.

FAQ #1: Can I do a Roth conversion inside the TSP (to turn my Traditional money into Roth)?

The very first question, can I do a Roth conversion inside the TSP to turn my Traditional money into Roth? Now, I already told you guys the TSP does not allow this strategy to happen inside your TSP account. This is called an in-plan conversion. They do not allow that.
The only way that you are able to make this money Roth money, is to move the money to that Traditional IRA and then do the Roth conversion that we saw in the prior slide.

It’s also worth noting because of the rules set up by the TSP, they do not accept Roth IRAs into the account. They’ll accept Roth 401(k)s. (so an old employer that you had that you had some 401k money with, that’s a different deal). But a Roth IRA once that is established in the private sector, you are not allowed move it back into the TSP. You want to make sure that you are feeling good about what you’re doing and that you have all your T’s crossed and your i’s dotted to make this work.

FAQ #2: I heard I make too much to do a Roth conversion – is that true?

Gosh, we hear this all the time and no, that’s not true. There are no income limits set on Roth conversions. There are if you’re contributing directly to a Roth IRA, but on the conversion itself, there’s no income limit. It doesn’t matter how much you make, you are eligible to do a Roth conversion.

FAQ #3: Is there any limit how much I can convert in a Roth conversion?

Next question, is there any limit how much I can convert in a Roth conversion? The good news is no. There are no limits to the amount of the Traditional money that you can convert to Roth money.

It is important to remember though, that you owe tax at the time of the conversion. That might keep you from wanting to move all of that money in a single tax year. Most of the time we find people spreading out that conversion, so several little conversions over several tax years so that they’re converting those chunks at a time and spreading out that tax burden. You could do it all at once, but probably not advisable just given the tax situation.

FAQ #4: “Can I use some of the money in the Traditional TSP to pay the tax owed on the Roth conversion?”

This is my favorite answer, which is “yes, but.” Yes, but you should avoid doing it because one, it lowers the amount that’s actually being converted. Remember, the whole reason we’re doing this Roth strategy is to create a big bucket of money that is growing tax-free. If you take a chunk out of that money to pay the tax on it, you now have less money working in that tax-free environment.

The other thing that I would caution you on is if you are under 59 1/2, let’s say you retired and you’re 57 and you decide to do a Roth conversion, if you take money from the Traditional TSP to pay the tax on this money, on this conversion, you are going to be subject to a 10% early withdrawal penalty because if you’re using that money to pay the tax, you’re receiving that and now we’re going to have a problem.
Very important that we understand the rules here and not put ourselves in hot water. Always, always try to find that money to pay the tax outside of the account that you’re converting.

FAQ #5: Do I have to be a certain age to do a Roth conversion?

The answer is no. There are no age restrictions whatsoever on when you’re allowed to do this. It is important to know though, if you’re still working, you are not going to have access to your TSP to even do this until you retire. Or if you’re still working and you reach that 59 1/2 mark, you’ll be able to do it then. If you’re 50 and you’re listening to this session, you might say, okay, cool. I’m going to go ahead and start the conversions between now and 10 years from now when I plan to retire.

Yeah, that all sounds great, but the TSP won’t allow you to access your account to do that. There might be some other tax strategies that you could discuss with a financial professional, but as far as being able to do that with your TSP money, that’s not quite going to work.

You want to be cautious about doing a large conversion as you near age 65. At 65, although you’re not required to enroll in Medicare part B, most of you, that is the point that you’re making the decision on your Medicare part B health insurance. All of that money that you convert from Traditional to Roth is going to count as income to you and that will determine how much you pay for Medicare Part B. Now here’s the deal. This is not a total deal breaker.

If you are nearing that age 65 window, Medicare always looks back two years to see what your income was two years ago to determine your premium. Now if you’re 65 and enrolling in part B, so they’re going to look back two years. If you’ve converted anything at age 63, 64, that is going to be looked unfavorably for you for Medicare Part B, it still might be worth it though.

You have to look at the bigger tax situation that you are trying to create for yourself. What I love is when we’re doing the analysis on a Roth conversion of seeing whether it’s really worth it or not, you’re going to be able to see, okay, yeah, yeah, I had to pay some extra premium for part B that maybe wasn’t so happy, but I ended up putting myself in a way better tax situation and that far outweighed the extra premium that I had to pay.

Conversely, if that’s not the way that the numbers shake out, then you at least know that. It needs to be part of this conversation, but it’s not a total deal breaker.

FAQ #6: When is the deadline to do a Roth conversion?

For tax purposes, sometimes the IRS extends deadlines up until the time that filing to be able to do things for the prior tax year. That is not the case for a Roth conversion. Those have to be done by December 31st of that tax year. And just remember any of the money that you are converting has to be reported as taxable income for that year. That is the year that it was converted, and you’re going to owe that tax in that tax filing year.

FAQ #7: “If I do a Roth conversion, do I have to wait to withdraw the money?”

The answer is yes. Any Traditional TSP money that you make Roth IRA money through this Roth conversion process, it starts a 5-year clock. It’s super important that you know, don’t need to access that money during that time.
It’s not to say you can’t, you can with a penalty, which kind of defeats the purpose of what you’re doing, but it’s important that you know that this is a little bit longer term strategy that you can’t turn around and take the money out immediately without some consequences.

Keep in mind the idea with the Roth account is that you want the money in that bucket to grow for as long as possible because it’s growing tax-free. We don’t want to turn around and take the money out. This is a longer term strategy that you’re trying to get lots of growth in that account.

FAQ #8 “What happens if I do a Roth conversion and then I end up needing the money before 59 1/2 or before that five years has passed?”

What if I thought it would be okay, but now all of a sudden I need the money? From a Roth IRA, you can withdraw your principal. That is the money that you converted into the account at any age without paying taxes or penalties. So your own money you can take out because you already paid tax on that.

But if you end up withdrawing any of the gains from a Roth IRA without meeting both the age 59 1/2 and the 5-year rules, you may owe tax and penalties on that part. The IRS has made this overly complicated. You can go to irs.gov for some exceptions to this of certain conditions that might allow you to access this money tax-free.

The good news is if you’re rolling over and converting a lot of money, you have a lot of principal in there and so you’re able to access that without penalty. There are some exceptions to all of these things that are worth noting and worth talking about.

FAQ #9: “If I am in a state that does not have income tax, are Roth conversion still a good idea?”

This is such a good question because we have to be looking at the whole tax picture. So I’ll say maybe because it’s worth having a conversation to look at that bigger picture, not just the state income tax, but we have to look at the whole situation that you are in.

State taxes should certainly be part of the discussion and that goes into your decision. Of course, I do want to make a special note because sometimes we lose sight of this, that even if you’re in a state that does not have income tax, you will always owe federal tax on any Traditional distribution. It doesn’t matter what state you live in, you’re going to owe it at the federal level. You’re not going to outrun or out move the federal government on getting their tax.

FAQ #10: “If I’m in a state that doesn’t tax TSP or IRA distributions, is a Roth conversion still a good idea?”

This is almost as good as being in a state that doesn’t have any income tax. It’s just different. In this question, this would be somebody who lives in a state that normally has income tax but is specifically excluding the TSP or IRA distributions at the state level. Just remember, wherever you receive the money is where you are going to pay tax.

You might be in a great tax environment now based on where you live, but if you end up moving, you’re going to pay the tax at whatever level it is at the state in which you move. I wanted to put the states on here that do not tax TSP at the state level (there are 13 of them).

If you happen to be in one of these states or will be in one of these states, when you retire and take the money, you are not going to have state income tax on your TSP or IRA distributions. But that does not mean that you don’t have a tax obligation at the federal level. I just want to stress that because sometimes that part is overlooked.

FAQ #11: “If I do a Roth conversion and later change my mind, can I undo it?”

The answer is no. It used to be that if you did a Roth conversion and you’re like, oh no, I didn’t realize I was going to have all this extra taxable income for maybe another source and this didn’t end up being in my favor, can I undo it?

You used to be able to do that, but that is no longer allowed since 2018 that the current law simply prohibits this type of undoing of a Roth conversion, which is ever more reason why you want to make sure that you’re doing the right thing when you do this conversion. This isn’t to dissuade you from doing a conversion, it’s simply to make sure that you do it right because there aren’t any do-overs. You definitely want to make sure that we get this all squared away and it’s done exactly the way you intend.

FAQ #12: Do Roth accounts have Required Minimum Distributions that make me take money out once I’m 73 and older?”

You’ve probably heard this on Traditional accounts (Traditional IRAs, Traditional TSP). The answer here though is no. Both the Roth IRAs and Roth TSPs are exempt from Required Minimum Distributions. Now, this is a rule for the Roth TSP that just changed this year, and so it used to be completely convoluted, at least we’ve got that squared away now.

Roth IRAs and Roth TSPs are both excluded from Required Minimum Distributions. You’re going to be able to allow these accounts to grow tax-free for your whole lifetime if you wish. We’ll talk about what happens when your lifetime ends and somebody else gets the remainder of this money here in just a moment. I do want to stress though Traditional TSP and Traditional IRAs have Required Minimum Distributions.

And some of you might be thinking, “well, I’m probably going to need money anyway. What’s the big deal for an RMD?” But what happens if you actually don’t need the money?

These RMDs are going to require you to take it out and pay tax on it even if you don’t need it. You might be in a situation where you’ve got pretty good income (not from a job, but from different sources coming in for retirement) and you’re like, gosh, I don’t really need that money, or I don’t want that money from that account because taxes are really high right now. Too bad, so sad. If it’s Traditional TSP or Traditional IRAs, RMDs are going to be required.

FAQ #13: “If I die with a Roth IRA, do my beneficiaries receive the money tax-free?”

The answer is yes, and that’s why the Roth accounts are so favorable in the eyes of financial professionals, legacy planning, all of this when you’re thinking about what happens to my money when I’m gone. This is a huge perk for Roth accounts, and this goes for your Roth TSP two. The question was about the IRA, but I want to let you know that if you have Roth TSP that you’ve contributed directly to the Roth TSP, when that money comes out, it’s going to be tax-free to your beneficiaries. Amazing.

The beneficiaries don’t necessarily have to take all the money out at one time. The good news is they can leave that money in the account and allow it to grow tax-free for up to 10 years before they’re required to take the money out. They’re not going to owed tax when they take the money out. But how cool is it that they’re able to keep that money in this styled account like a Roth IRA would simply have a beneficiary account to it that they’re able to continue to let that money grow and grow and grow over all those years, especially if they don’t need it.

A really cool option because remember, if they wanted to get into a Roth IRA, they would have to contribute directly and they’re only allowed to contribute $7,000 or maybe $8,000 a year with this. If you’re leaving them a bunch of tax-free money, it can continue to grow for up to 10 years before they have to take it out.

It’s a really cool option with the Roth styled accounts that planners really love because nobody wants to think when I die, now all my stuff is taxable to my family. Roths allow for that transfer of wealth between generations.

FAQ #14: “Who can help me assess whether a Roth conversion strategy makes sense (and if so, make it happen)?”

I hope I have stressed enough today that this is a complicated process. I’m just touching on the wave tops of the rules of how this stuff works. Please seek professional help to do a Roth conversion. In an ideal world, your tax professional is at least able to provide the necessary data. Prior years tax returns, anything that would influence these numbers so that a real proper assessment can be done to determine if that Roth conversion is an advantageous move.

It’s not the CPA, it’s not the tax professional who is determining whether you should or should not do this because they don’t know the rest of your financial life. It is important to appreciate that you need to be working with a licensed financial professional to give some financial context and analysis on what the overall tax situation is, and they’re the ones that do that analysis and make the account recommendations.

So we have to provide tax awareness to people when they’re making decisions on what types of accounts they should be in, and we want to make sure that you’re getting that from someone who has an obligation to look at the entire picture that you have.

The Biggest Challenges According to the Pros

When we think about the biggest challenges with the Roth conversion, I spoke to some of the financial professionals that we have in our program. These are long-term members of ours who have specialized their practice to work with federal employees. I asked them about kind of the biggest challenges that they see according to the pros, right? They are the professionals that deal with this stuff, so here are some of their comments.

Challenge #1: Taxes are always a moving target.

If we looked 20 years ago and we tried to imagine the tax situation that we’re in right now, it’s hard because our situation, life has changed, our income levels have changed, the tax environment has changed. It’s always something that requires relooking at and keeping up with over the years.

Challenge #2: If not’s IF, it’s WHEN you’ll pay taxes

You get to decide when you’re willing to do that within the parameters that the IRS has set, right? Don’t be getting in trouble, tax troubles, no fun and retirement, but you get to decide when you’re going to pay those taxes now or later. You might find that there are some advantages and disadvantages on both sides.

Challenge #3: This process is not pain-free

This process is not pain free. Roth conversions can be tough, but the goal here is to make the least painful move, right? Take the least painful route on the way to a tax-free retirement or to have more tax-free available to you in retirement. Nobody loves stroking that check to the IRS, whether it’s your normal annual check that you write to make up the difference of what wasn’t withheld from your paycheck or something bigger like a Roth conversion. Nobody loves stroking the check, but know that it’s the last tax check that you’ll write on that money, and that is a beautiful thing.

Challenge #4: Roth conversions are complicated

When we look at the long-term effect of a Roth conversion, this process is super complicated and it unfortunately wields a lot of consequence if it’s done incorrectly. It is something you cannot take back, so you have to make sure that it’s done right from the very beginning.

Challenge #5: You get to choose to be proactive or reactive

This is the biggest part of Roth conversions that I really want to drive home, and that is you get to choose whether you’re going to be reactive or proactive in the tax world. The fact that you even have a Traditional TSP where you have deferred taxes is giving you an opportunity now to acknowledge that the tax train is coming and you’re going to be proactive in the way you are going to address it by doing some of that now.

You don’t have to do all of it now, and I use now loosely, each of you are different ages in different situations, but the idea that you can be more in the driver’s seat of what taxes are going to look like if you give yourself some choices.

And the only way to have choices on how your money is taxed is to have different buckets filled, Traditional buckets, Roth buckets. Each of them have their advantages. We’re not suggesting to move all of your money over to a Roth account. There’s probably going to be some sort of balance there that needs to be struck.

Attend a FedImpact Workshop

You guys know when it comes to these big challenges, TSP is not the only thing that you’re having to deal with. Certainly even from a tax standpoint, there’s a lot of tax consequences in the other benefits that you have as federal employees. Our job is to help you to figure out how to be the hero in your own retirement story so that you walk into retirement held high, you’re confident that you’ve taken all the steps possible to give yourself the greatest advantage in retirement – not just on taxes, but the whole picture. I implore you to please attend a workshop.

We have in-person training, there is no cost for you as the employee to attend. And we’re covering all of the federal benefits topics and those decisions to be made. And here’s the part that I really love. I say this at the end of each one of these sessions, but it’s so important that one-on-one help is available.

If this idea of Roth conversions has been exciting to you and you’re like, wow, I at least need to have the conversation about this, consider getting to one of these workshops, getting a good sense of the bigger picture that you’re going to be dealing with in retirement and use some of that one-on-one time that’s available to you after the session in the weeks following the session to have that bigger conversation about Roth conversions and if this a right strategy for you to consider further.

You guys can see all the details of the workshops, the locations, the dates, the agenda, all of that good stuff at FedImpact.com/attend. You’ll be able to find a workshop hopefully in your local area. We’ve got lots of them out there, although we can’t be in every city. We do have quite a few, so please check that out and get registered for a workshop near you.

Thank you so much for joining us. I that you’ll stay tuned for benefits and news updates. Like I said, you can certainly find a workshop at FedImpact.com/attend and you can certainly see the details of our upcoming webinar at FedImpact.com/webinar. There you’ll find all of the replays of past webinars that are still current information. All those are available to you to be able to access. Thank you all for joining us for this session.