Since 2013, federal employees have had the option of contributing to the Roth Thrift Savings Plan (TSP). Employees can also contribute to the traditional TSP, as they have been able to since 1987. The question is: Which TSP retirement account – the Roth TSP or the traditional TSP – is the more appropriate choice for the average federal employee?
Before discussing which TSP account is the more appropriate choice for a federal employee, it is important to review how each TSP account works with respect to federal and state income taxes. Both the traditional TSP and the Roth TSP are tax-favored retirement savings plans that encourage federal employees to set aside dollars now and withdraw these dollars in retirement.
The differences between the traditional and Roth TSP accounts begin with respect to how a TSP participant contributes to each account and concludes as to how a TSP participant withdraws from each account. Contributions to a traditional TSP are deducted from an employee’s gross salary, resulting in current-year tax savings for federal income and in many states, state income taxes. Once contributed via payroll deduction, the employee’s contributions accrue earnings (interest, dividends, or capital gains) in the various funds available in the TSP – C, S, I, F and G funds, and the Life Cycle funds. With the traditional TSP, the contributions and accrued earnings are not taxed until the earnings and contributions are withdrawn in retirement. The following example illustrates:
Example. Joan contributes to the traditional TSP. During 2019, Joan’s gross salary will be $90,000. Joan plans to contribute $19,000 to her traditional TSP during 2019. If she does, then her 2019 taxable salary will be reduced to $71,000 ($90,000 less $19,000). Joan will pay federal and state income taxes on the $19,000 contributions, together with the accrued earnings when she withdraws these contributions and accrued earnings in retirement.
With the Roth TSP, contributions are made with after-taxed dollars (contributions are deducted from an employee’s salary which is first subject to federal and state income taxes) resulting in no current-year tax savings. The after-taxed contributions will therefore not be taxed when they are withdrawn in retirement. The Roth TSP participant has access to the same funds as a traditional TSP participant. In retirement, the Roth TSP participant will not pay income tax on the withdrawn accrued earnings provided the Roth TSP participant is over age 59.5 when the Roth TSP funds are withdrawn, and it has been at least five years since the Roth TSP participant made his or her first Roth TSP contribution.
Choosing the Roth TSP is often more expensive in the short run because the Roth TSP participant pays income taxes “upfront” on the contributions. But this drawback has an upside. The upside is that no taxes will be paid on any of the accrued earnings when they are withdrawn after the Roth TSP participant is over age 59.5.
The annual contribution limit is the same for both the traditional TSP and the Roth TSP – $19,000 per employee under age 50 or $25,000 for those employees over age 49 as of Dec. 31, 2019. An employee can actually contribute both to the traditional TSP and the Roth TSP accounts but the employee’s total TSP contributions for 2019 cannot exceed $19,000 for federal employees younger than 50 and $25,000 for federal employees over age 50 as of Dec. 31, 2019. For those employees covered by FERS, automatic (1% of gross pay) contributions and matching contributions made by the employee’s agency will be made to the employee’s traditional TSP account, no matter how much the employee contributes to the Roth TSP.
When is it an appropriate investment move to contribute to the Roth TSP? Financial and tax professionals cite this general rule of thumb: If a retirement saver expects to be in a higher marginal federal and state tax rate at the time he or she withdraws retirement plan monies compared to the retirement saver’s marginal tax rate when the monies are contributed to the retirement plan, then the Roth account is the better option.
While tax rates in several decades are hard to predict, it is likely that today’s younger employees under the age of 30, and whose top federal marginal tax rate may be as low as 12 percent, will likely be in a higher tax bracket in retirement. In that case, contributing to the Roth TSP today makes good sense.
On the other hand, if a 50-year-old employee’s top tax rate is currently 33 percent, then it is likely that the employee’s tax rate in retirement will be lower. In that case, contributing to the traditional TSP today makes good sense.
In practice, tax professionals and retirement specialists say that funding a Roth TSP often makes sense for younger employees and those employees close to retirement. Younger employees can expect their income and tax rates to rise while older employees are more able to predict their soon-to-be retirement tax rates. Employees should also consider where (which state or country) they will be living in retirement (at which time they will be withdrawing their TSP accounts) when deciding which TSP account to fund. Some states have no income tax and will therefore not tax TSP withdrawals. Some foreign countries will tax TSP withdrawals, although if that foreign country has a tax treaty with the US, then the TSP account owner is eligible to receive a foreign tax credit on his or her US income tax return on taxes paid to the foreign country for TSP withdrawals.
Some other considerations:
· As mentioned above, it is not a matter of choosing “either one TSP account or the other TSP account”. An employee can contribute to both the traditional TSP and to the Roth TSP during 2019. Total contributions cannot exceed $19,000 for employees younger than 50 during 2019 and $25,000 for employees over age 49 during 2019. FERS employees always have their agency contributions (automatic and matching) put into their traditional TSP account, even if the employee contributes only to the Roth TSP.
· When will the TSP funds be needed? Roth TSP is different from a Roth IRA. Contributions to a Roth IRA (made with after-taxed dollars) can be withdrawn tax-free if needed such as to pay for an emergency, or to use for a house down payment. But Roth TSP contribution withdrawals before age 59.5 often incur taxes or penalties.
· Do not neglect “tax diversification”. All employees should consider how they can save on taxes both now and in the future. Contributing to the traditional TSP results in current-year tax savings, while contributing to the Roth TSP results in future tax savings. This is what tax professionals call “tax diversification”. Few individuals can guess what their future tax rates will be. But dividing retirement savings into different tax “baskets” – that is “before-taxed” (traditional TSP) and “after-taxed” (Roth TSP) provides flexibility both now and in the future.
Edward A. Zurndorfer is a Certified Financial Planner, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, located at 833 Bromley Street Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While the employees of Serving Those Who Serve are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.