The Thrift Savings Plan, “TSP”, has always been a good way to save money for retirement. It’s gotten even better in 2012 with the addition of a “Roth” option for contributions. Before going into the details of the new choices, I’d like to start with a quick refresher on the existing TSP program.
In the TSP, much like a private sector 401(k), all contributions are made pre-tax. Taxes are also deferred on the growth of the account, and finally paid upon withdrawal of the funds at the current rate. In exchange for these tax benefits, funds must be held in the account until age 59½ to avoid a 10% withdrawal penalty. At age 70½, withdrawals are mandated to be taken based on your life expectancy. These are called “Required Minimum Distributions”, or RMD’s.
In contrast to the existing TSP program, a contribution designated as a Roth contribution is made as an after-tax deposit. If the funds are held in the account for at least 5 years and you are over the age of 59½, the money in the account is never taxed again. That includes the growth of the account, which could be significant if the funds are invested for a long period of time. There are no RMD’s for a Roth account.
The contribution limit to the TSP is $17,000 per year for 2012, up $500 from 2011. If you are over the age of 50, you can also make an additional $5,500 “catch-up” contribution. These limits include all deposits, whether in the standard account or a Roth account. Participating in the TSP does not preclude your ability to utilize a personal IRA outside of TSP as well, though there are some income limitations for contribution deductibility.
The limits above apply only to your contributions to the TSP account. The government also makes deposits into your account. For a FERS employee, you would receive an automatic contribution of 1% of your salary, a dollar for dollar match on the first 3% of your salary you elect to withhold, and a 50% match on the next 2% of withholding. That means that if you elect to withhold 5% of your salary, the government will be adding an additional 5%, for a total of a 10% contribution. There are no more matching funds past the 5%. With respect to Roth contributions, they will still count for matching funds, but all deposits made by the government will be standard, pre-tax contributions. That means a 5% withholding into a Roth account will result in 5% going to the Roth, and the government contributed 5% going to the standard account.
With that technical discussion out of the way, the primary question is whether or not to designate all or part of your contributions after the new option is available as Roth contributions. There are three main reasons that you would want to consider a Roth contribution.
Age
Younger workers, with a long time until retirement, have the best opportunity for large amounts of growth in their retirement account. If you begin early in your career, it is possible at retirement to have more of your account value consist of earnings than contributions. In the standard TSP, all of the final value will be taxed at full income tax rates. For Roth accounts, only the smaller amount of the original contributions would have been taxed.
Taxes
Since taxes in a Roth account are paid right away and taxes on the standard account are paid at withdrawal, there is the potential for the tax rates to be significantly different. The two primary reasons for a difference would be the tax bracket and the rates themselves. For employees in a lower tax bracket that expect to be in a higher bracket later, it often makes sense to make Roth contributions to have a lower effective tax rate on their savings. The other consideration is regarding the actual rates. If you expect them to go up in the future, it could make sense to simply pay the taxes now at the current rate and not risk having to pay a higher rate in the future.
Diversification
When you get to retirement, there are many different strategies to consider with respect to drawing income from your investments. Many of those have to do with tax minimization, and keeping yourself in the lowest tax bracket possible. One of the best tools to give you options at that time is a Roth account that won’t be subject to any further tax. For higher income earners who may not be eligible for a Roth IRA, the Roth TSP is the only real option to contribute to that type of account.
The final decision on whether to make contributions to a standard or Roth TSP account is a very personal one, and will depend on many factors. It could also have a large impact on your retirement and the choices you’ll be making then. I strongly recommend speaking to an experienced financial professional who can help you run through all of the possible scenarios and make the best decision possible for your situation. If you do decide to make Roth contributions, keep an eye out for information from TSP on how to make the proper elections.
In the TSP, much like a private sector 401(k), all contributions are made pre-tax. Taxes are also deferred on the growth of the account, and finally paid upon withdrawal of the funds at the current rate. In exchange for these tax benefits, funds must be held in the account until age 59½ to avoid a 10% withdrawal penalty. At age 70½, withdrawals are mandated to be taken based on your life expectancy. These are called “Required Minimum Distributions”, or RMD’s.
In contrast to the existing TSP program, a contribution designated as a Roth contribution is made as an after-tax deposit. If the funds are held in the account for at least 5 years and you are over the age of 59½, the money in the account is never taxed again. That includes the growth of the account, which could be significant if the funds are invested for a long period of time. There are no RMD’s for a Roth account.
The contribution limit to the TSP is $17,000 per year for 2012, up $500 from 2011. If you are over the age of 50, you can also make an additional $5,500 “catch-up” contribution. These limits include all deposits, whether in the standard account or a Roth account. Participating in the TSP does not preclude your ability to utilize a personal IRA outside of TSP as well, though there are some income limitations for contribution deductibility.
The limits above apply only to your contributions to the TSP account. The government also makes deposits into your account. For a FERS employee, you would receive an automatic contribution of 1% of your salary, a dollar for dollar match on the first 3% of your salary you elect to withhold, and a 50% match on the next 2% of withholding. That means that if you elect to withhold 5% of your salary, the government will be adding an additional 5%, for a total of a 10% contribution. There are no more matching funds past the 5%. With respect to Roth contributions, they will still count for matching funds, but all deposits made by the government will be standard, pre-tax contributions. That means a 5% withholding into a Roth account will result in 5% going to the Roth, and the government contributed 5% going to the standard account.
With that technical discussion out of the way, the primary question is whether or not to designate all or part of your contributions after the new option is available as Roth contributions. There are three main reasons that you would want to consider a Roth contribution.
Age
Younger workers, with a long time until retirement, have the best opportunity for large amounts of growth in their retirement account. If you begin early in your career, it is possible at retirement to have more of your account value consist of earnings than contributions. In the standard TSP, all of the final value will be taxed at full income tax rates. For Roth accounts, only the smaller amount of the original contributions would have been taxed.
Taxes
Since taxes in a Roth account are paid right away and taxes on the standard account are paid at withdrawal, there is the potential for the tax rates to be significantly different. The two primary reasons for a difference would be the tax bracket and the rates themselves. For employees in a lower tax bracket that expect to be in a higher bracket later, it often makes sense to make Roth contributions to have a lower effective tax rate on their savings. The other consideration is regarding the actual rates. If you expect them to go up in the future, it could make sense to simply pay the taxes now at the current rate and not risk having to pay a higher rate in the future.
Diversification
When you get to retirement, there are many different strategies to consider with respect to drawing income from your investments. Many of those have to do with tax minimization, and keeping yourself in the lowest tax bracket possible. One of the best tools to give you options at that time is a Roth account that won’t be subject to any further tax. For higher income earners who may not be eligible for a Roth IRA, the Roth TSP is the only real option to contribute to that type of account.
The final decision on whether to make contributions to a standard or Roth TSP account is a very personal one, and will depend on many factors. It could also have a large impact on your retirement and the choices you’ll be making then. I strongly recommend speaking to an experienced financial professional who can help you run through all of the possible scenarios and make the best decision possible for your situation. If you do decide to make Roth contributions, keep an eye out for information from TSP on how to make the proper elections.
