Why Put Tax-Free Money in TSP?

[imnot12]

First off, thanks everyone for sharing your knowledge and experience. This forum is a great source of info.

Like many military members, I stumbled onto the site while searching for TSP insights because of a deployment (not a 365). I fully understand the differences with Trad IRA, Roth, and TSP and the corresponding limits. This question is specific to investing tax-free pay and allowances in TSP:

I cannot figure out the advantages to using your tax-free income from pay and allowances associated with a combat zone in your TSP. That cuts out arguably the biggest reason to use TSP in the first place - tax deductibility. By using tax-free income, you've missed out on the tax break from lowering your taxable income.

I understand that tax-free money stashed away in the TSP is tax-free upon withdrawal. That makes sense, but it will ALWAYS be tax-free, in essence, in ANY investment vehicle. The earnings in either case, TSP or other account, will be taxed. The only difference is when I decide to pay that tax, annually or during retirement. For example, I could deposit that tax-free cash in a savings account or mutual fund (comparing rates aside) and always be able to get at the principal, that original chunk, without a tax penalty (i.e. only being taxed on interest or gains). I’m not sure if I explained that correctly, but my point is the TSP does not provide a unique shelter for tax-free income, right?

The part I do get about maxing a TSP during a deployment is the increased limit. That is an opportunity to put a large amount of extra money away for the future. However, if you need the TSP to protect that money from yourself, that is a different matter. Also, I see the benefit if one is trying to sneak the tax-free money around to a Roth after separation.

I have read many posts here lauding TSP and deployment benefits. I saw a few responses that bring up the points here, but I didn't get a conclusive answer. I just want to make sure I get it right. Thanks everyone for your thoughts.

 

[tsptalk]

Welcome imnot12. You bring up some good points, and while I'm not up on all of the military payment benefits, I tend to agree with you.

The only benefit of the TSP in a case where your contribution money is tax free is the low cost of doing business. Otherwise, most IRA vehicles will provide you the same benefit and that is, deferred taxes on your gains. In a non-retirement account you will obviously have to pay taxes on your sales annually, but you will have no hassle access to your money. That's the trade off.

I know I'm stating the obvious so I will let our military folks tell us what we may be missing here.

 

[Frixxxx]

Remember that tax-free means that.

If you earn tax free money...its yours...TSP contributions don't help you in the tax year, but still help you save.

The real investment for those in the tax free arena is Roth IRAs. After tax investments that don't get taxed later.

Most Active Duty in the TAX FREE arena should focus on the ROTH.

The true exception should be if your spouse is working and you still need to offset your tax liability. Then TSP works in your joint filing.


Hope that helps!

 

[Birchtree]

The opportunity is the capital appreciation potential over time regarding your fund choices. The fees are minimal and your control is versatile. You have flexability and if your frequent this board you'll get much free experience so you are not investing alone.

 

[NWC07]

First off, thanks everyone for sharing your knowledge and experience. This forum is a great source of info.

Like many military members, I stumbled onto the site while searching for TSP insights because of a deployment (not a 365). I fully understand the differences with Trad IRA, Roth, and TSP and the corresponding limits. This question is specific to investing tax-free pay and allowances in TSP:

I cannot figure out the advantages to using your tax-free income from pay and allowances associated with a combat zone in your TSP. That cuts out arguably the biggest reason to use TSP in the first place - tax deductibility. By using tax-free income, you've missed out on the tax break from lowering your taxable income.

I understand that tax-free money stashed away in the TSP is tax-free upon withdrawal. That makes sense, but it will ALWAYS be tax-free, in essence, in ANY investment vehicle. The earnings in either case, TSP or other account, will be taxed. The only difference is when I decide to pay that tax, annually or during retirement. For example, I could deposit that tax-free cash in a savings account or mutual fund (comparing rates aside) and always be able to get at the principal, that original chunk, without a tax penalty (i.e. only being taxed on interest or gains). I’m not sure if I explained that correctly, but my point is the TSP does not provide a unique shelter for tax-free income, right?

The part I do get about maxing a TSP during a deployment is the increased limit. That is an opportunity to put a large amount of extra money away for the future. However, if you need the TSP to protect that money from yourself, that is a different matter. Also, I see the benefit if one is trying to sneak the tax-free money around to a Roth after separation.

I have read many posts here lauding TSP and deployment benefits. I saw a few responses that bring up the points here, but I didn't get a conclusive answer. I just want to make sure I get it right. Thanks everyone for your thoughts.

You bring up a good point.

I do think it is a great way to "catch up" for those who may have neglected contributing to their TSP in the past.....

 

[imnot12]

Tom - thanks for the quick reply. Good point on access to the money. Putting tax-free dollars in TSP might limit your options.

Frixxxx - exactly right on both accounts. Tax-free TSP allotments do not help in the current tax year. ROTH should most certainly be the priority.

Birchtree - thanks for the reply. I do not discount TSP as a solid tax-deferred, low-cost saving option. My comment was purely geared towards using tax-free income as the investment.

 

[Frixxxx]

Glad I could help.

You are smarter than most asking questions like that. Spread the wealth of knowledge and get some of your peers and subordinates to jump on the investment bandwagon and get them on this site!

Be Safe Out There!

 

[Show-me]

My two cents is Roth first, beings it is tax free and gains and withdrawal would be tax free.

 

[PessOptimist]

There has been a lot of discussion on the MB about tax free income and Roth IRAs. I have no personal stake in this as I seriously doubt I will ever be called to serve in an area where I get tax free income. I am just going to ask a bunch of dumb questions and hope the answers will help some of our people serving.

Assuming that most GIs meet the requirements, they can contribute $5k this year to a Roth IRA.

Unless all income this year is tax exempt, no one really knows if the $5k was tax free or not. So all discussions about that are moot.

If I understand the IRS rules correctly, most will not have to pay taxes on the increased value of the Roth IRA. For example, $5k put in a Roth IRA in 2010 increases in value over time to $6k. If the owner is 59.5 years old and meets other requirements (five years etc.), there is no tax on the $1k increase when it is withdrawn.

If the above paragraph is true, putting $5k in a Roth if you earned that much tax free is a good move.

Someone please correct me if I am wrong. Are earnings on a Roth IRA not taxable as income when you withdraw them?

 

[Frixxxx]

Where's Rod? He would know this best!

 

[imnot12]

Thanks everyone for the continued discussion. However, I think we've veered from the premise of my original question.

PessOptimist - you are correct. Earnings in a ROTH IRA are tax-exempt. Since the original contributions were already taxed, withdrawals are tax-free.

I agree with all of you, in most circumstances and ESPECIALLY with tax-free income, ROTH is the preferred method. However, my original thought was specifically about using tax-free income for your TSP.

I could try the math behind it, but it mostly comes down to forecasting rates of return, future tax rates, and future tax bracket; the same as pretty much all retirement problems. Simply, by using tax-free income in your TSP you are wagering that the low-cost structure of the TSP and your future tax situation - without a current tax-year deduction - would be better than any other investment.

I am inclined to contribute only in my non-deployed months for 2010.

 

[OMA]

During my deployment to Afghanistan, I maxed both the ROTH and TSP contribution. I figured the TSP grew tax deferred, so I opted for it - and being in the war zone, if I recall correctly, you're allowed to contribute a huge amount to the TSP when normally you can only contribute 15-16k/yr.

Just retired from the Army - now considering a TSP to ROTH conversion over 3-4 yrs. Weighing my options. Not sure that it will be worthwhile since I'll be in a lower tax bracket in my golden years.

 

[mtnstyne]

Here's a thought:

I am currently in Iraq and have already maxed my Roth IRA's for both 2009 and 2010. I can continue to put tax free money into TSP while I am deployed. When I retire, I can roll over the TSP into my Roth IRA and the tax free contributions won't be taxed (hence tax free...lol). I will have to pay taxes that year on the earning but only on the earnings. Of course if I contribute taxable income while not in a combat zone (I have not used TSP outside combat zones) I would have to pay the taxes on that as well, but for the most part I don't plan on using TSP.

The way I see it is that I can use the TSP as a backdoor to contribute additional funds to my Roth IRA and get past the $5,000/year limits.

Any thoughts?

Nice forum by the way.

mtn

 

[Frixxxx]

Remember, Roth IRA is taxed money now, but not taxed later.....deployed people paying NO taxes benefit from this........

TSP is tax-deferred....you pay taxes on it LATER. If you are not paying taxes on any earned income then it is only a "savings" channel.

So the trick is to balance out your tax liabilities.

You will have less tax breaks as you get older. You'll have paid off the house....you'll have no kid write-offs...etc

So, you'll want the majority of your income to be off the radar...I didn't max my TSP until I was off-setting it with a Roth IRA.....

So, the answer to this thread is ONLY if you have no other investment avenue.......

 

[anthony]

You've probably already read this, but I'll post if for others awareness:
TSP to Roth Rollover FAQs from TSP.gov

I agree that the best thing it serves as is a backdoor way to pump a bunch of money into a Roth account.

And as you stated, you will have to pay taxes on earnings and other taxable contributions, no different than converting a Traditional IRA to Roth IRA.

So, ideally if you do something like this you time it to happen in a year when you already have a low AGI -- maybe while going to school, or if you EAS in the same year that you have CZTE pay, or you move back in with your parents and eat peanut butter ... .

There are two other things you may want to consider:
1) TSP has very low expenses relative to mutual funds or brokerage commission fees for trading. Those expenses outside of TSP can eat away at earnings to some degree.
2) It would have to be researched to determine viability, but if you can work some arrangement where you keep a small amount in the TSP account (partial rollover?) it would be a nice safety feature to have it available. Let's say later in civilian life you are earning too much to contribute to a Roth, and you contribute to a 401(k) instead. Later you find that your corporation's 401(k) has high expenses compared to TSP. If your TSP account is still open (even if its just $50 or something) you could roll your 401(k) into your lower expense ratio TSP account.

Just some thoughts to keep in mind. Good luck.

Anthony

ps - where are you hanging your helmet?

 

[mtnstyne]

Thanks for the input Anthony. I guess more information about a persons situation always helps.

I will retire in the next couple years so all the earning in TSP will be limited to a short period of time and "shouldn't" affect my AGI too heavily. I am active duty and have a family so my AGI is never an issue when it comes to taxes and in todays modern Army I can be guaranteed some tax free dollars almost every calendar year with the possibilty of an occassional year of no deployments about every 3rd or 4th year. This is my third deployment since 2005 (2008 was the only year I didn't have deployed time). The unit I am in right now in Iraq is likely already planning for the trip to Afganistan even though we haven't redeployed yet.

I contacted a financial adviser about a partial rollover and the possiblity of doing just the tax free portion and it is not an option. Any rollover would be a proportionate fraction of the entire amount of taxable and non-taxable.

You have to keep at least $200 in TSP if not in govt service (able to contribute) or they just mail you a check for the balance.

My rationale for this plan is that if I deploy again before I retire I could put maybe $20k in TSP tax free over the next 3-4 years. At the same time I will put in another $20k in my Roth IRA. Lets say I am very fortunate and earn around 8% and my earnings in my TSP are around $10k. The year I retire I roll over the $30k from the TSP into my Roth and pay maybe a few more taxes that year (1.5k would be 15% on the 10k earnings and is what I estimate based on my earnings and assuming I don't deploy that year). That entire amount of $30k then will sit in my ROTH IRA for 15 years and grow tax free until I reach my 60th birthday. I haven't crunched the numbers yet (and maybe I should) but I am pretty sure that paying a little in taxes now will be way more beneficial than paying a lot of taxes on the earnings when I REALLY retire at around age 60.

2011 will quite possibly be the first year in 17 years that I might actually not recieve all the federal taxes I pay back in the form of a tax return. So far contributing to TSP hasn't been shown to provide any benefit, but maybe in the future and possibly during the tax free times.

Thanks again.

 

[Boghie]

An odd thought, but something to consider - maybe...

Putting tax free money into a tax deferred account is probably a hassle. You will have to somehow inform your buddies at the IRS every year regarding the portion of contributions that are tax free money. Then you will have to figure out a way to separate the growth and earnings of the tax free portion from the normal contributions. Only then - when you are enjoying your blissful retirement - can you claim a documented portion of your distributions are tax free.

Maybe there is a mechanism for our fighting forces out there. Maybe TSP breaks it down for you. But I haven't seen it.

If not, I don't think it worth the hassle, or the court time, or the potential for free room and board at the Greybar Motel.:nuts:

I would MAX out the Roth using inexpensive ETF/Mutual funds that map to TSP (S&P 500, Russell 2000, EAFE, AGG - see quotes). I would want a true cash vehicle (Money Market), a low cost REIT, a true Emerging Market Fund, and some commodities.

And, maybe even a Russian bride so you can double your contributions - yuk, yuk:nuts:

 

[SkyPilot]

My two cents is Roth first, beings it is tax free and gains and withdrawal would be tax free.

I beleive this is the best of all the strategies for tax free income... wish I could get some .