Guest post Wednesday: The importance of your retirement account Exit Strategy.

September 12, 2012 by · 1 Comment

 

This guest post is brought to you by Eddie Wills.

 

For those of us who have had to put together War Plans/OPLANs on a military staff, we all know the importance of an Exit Strategy. The late great author Dr. Steven R Covey, author of “The Seven Habits of Highly Effective People” knew this as well. His first (and likely most important) of the Seven Habits is:

Begin with the End in mind.

There’s so much focus in the financial services industry on how to save for retirement, and yet so little on the best strategies to get your money out. Sure, Fidelity, Schwab, or Vanguard will be happy to compute your Required Minimum Distribution for you when you turn 70½, but wouldn’t it be nice if you knew the most tax-efficient tactics over the long run to draw your retirement income? Maybe if you knew the most rapid strategies to access Retirement Account money penalty-free you could make a better-informed decision in choosing between Roth, Traditional IRA, or 401k/TSP accounts during your working years.

My best guess is that the financial services industry makes the lion’s share of its revenue (commissions and fees) when our retirement accounts are accumulating money, and that they have very little financial incentive in helping us choose the most efficient path to draw our account values down to zero at the optimal actuarial time (the moment our earthly bodies assume room temperature).

From reading some comments on this page and the Early Retirement forum, it’s clear to me that the vast majority of people don’t know some of the key rules about accessing money penalty-free from tax-deferred plans such as IRAs, 401ks, and Roth accounts. Sorry to paraphrase G.I. Joe, but knowing is half the battle:

Have a plan for withdrawing from your accounts.

Locking your money up in a Retirement Account for too long can cost you big bucks. Avoid the Red Lasers!

There are plenty of books on how to get out of debt, start saving for your immediate needs, and save for retirement. My favorite is Beth Kobliner’s book , “Get a Financial Life”. Start there if your only familiarity with CDs is you believe it is how people listened to music before the iPod.

For the rest of us on our way to saving for retirement, Begin with the End in Mind. The best book I’ve read is Dr. Twila Slesnick’s book “IRAs, 401(k)s & other Retirement Plans : Taking your money out”. Go grab a copy at your library or here. Now. Her book gives you vital information on how to retrieve retirement money penalty-free for health, home, education, leisure, and early retirement reasons. Knowing what Exit Strategies are available will help you choose the best Retirement Account vehicle for your goals.

Here are some of the key points regarding Retirement Accounts:

Retirement Account Misconception #1: I see post after post lamenting, “I guess I’ll just hang on with my employer until I can start drawing down my 401k at age 60”. This statement makes me grind my gears, because most people (falsely) believe that money in their 401k plan is stuck there until you turn 59½. Largely true, but if you terminate employment (for ANY reason- quit, fired, or retired) in the calendar year of your 55th birthday, you can start taking withdrawals from your employer’s 401k plan without penalty (you’ll still owe the IRS income tax, just not the 10 percent penalty). Caveat: While the tax code permits 401k withdrawals at age 55, you must check with your employer’s 401k plan administrator to ensure they have the accounting “hooks” in place to permit withdrawals at age 55. Most do.

Retirement Account Misconception #2: Another misunderstanding I frequently see is that people think their IRA money is stuck there until they are 59½. Also largely true, but there is a “Texas Two Step” you can take if you want your IRA money penalty-free at age 55. Here’s how it works- When you are 54 years old, apply for seasonal full-time employment at your favorite retail store (we’ll call it ‘CostMart’) during the Holidays. Roll some or all of your traditional IRA money (does not matter where it originally came from) in to the CostMart 401k as soon as you are eligible for employee participation in the CostMart 401k. Come January 1st, quit your job at CostMart and begin making penalty-free 401k withdrawals as discussed above. You’ve just made your IRA accessible without penalty- 4½ years early!

If a few extra months working for the Man turns your stomach, you could get really frisky with this option and start a solo-401k for your ‘consulting’ business… but I’d certainly enlist the help of an accountant before attempting this.

Retirement Account Misconception #3: Possibly the biggest misunderstanding is about Roth IRA contributions. Folks, you’ve already paid taxes on the cash you put in to your Roth account. It’s yours for the taking at any time for any reason. Example: You and your spouse want to set aside $10,000 for a trip to Hawaii to celebrate your anniversary in three years. You and your spouse each plunk $5,000 in to Roth accounts, choosing a 3-year CD paying 1.35% as the investment vehicle. At the end of the three years, each CD is worth $5,543. You and your spouse each pull out your original $5,000 and leave the $543 of earnings in each of the Roth accounts.

There’s some caveats here. In addition to being married to each other, you and your spouse are now also married to IRS form 8606 for life (it tracks your contribution basis to Roth accounts). It’s not that big a deal- tax prep software will keep track of this for you. Also, there are some tax land mines that have to do with Roth CONVERSIONS (a five-year holding period) and transfer/withdrawals from a Roth 401k. Consult your tax professional if either of these apply to you.

There are some rather esoteric methods I’m not covering here (like the 72(t) exemption) to get at your money early, but I’m just covering some of the most direct methods of accessing your Retirement Account money without penalty. If you want to read a bit more about 72(t) methods and Roth Conversions, Mr. Money Mustache has a quick summary. If you are really interested in converting your IRA or 401k to a 72(t) “self-annuity”, early-retirement pioneer John Greaney provides an excellent summary of 72(t) nuts-and-bolts.

For further reading, get Dr. Slesnick’s book for specific examples of advanced Retirement Account withdrawal strategies. Here’s a quick summary (remember to consult your tax professional before engaging):

Qualified Plan, IRA, and Roth IRA early withdrawal gouge sheet.

Qualified Plans

401(k)s, ESOPS, Money Purchase Pensions, Stock Bonus Plans, Keoghs.
See IRC Sec. 401

IRAs

Contributory/Traditional IRAs, SEP IRAs, SIMPLE IRAs, Rollover IRAs.
See IRC Sec. 408,
IRC Sec. 72(t)- Early Distribution Tax

Roth IRAs

See IRC Section 408(a),
IRS Reg. 1.408A- Roth IRA Regulations
Know this: - Below are IRS rules on “Qualified” Retirement Plans; your employer plan rules/documents may vary.- Exceptions listed below are 10% penalty-tax free, but you will still be taxed on all distributions as income. Exceptions listed below are 10% penalty-tax free, but you will still be taxed on all distributions as income. - “Contributions” to Roth IRAs are yours. You may withdraw contributions (not investmentreturns) at anytime for any reason, penalty and income tax free.- Exceptions listed below are both penalty-free and income tax-free.- 5-year holding/waiting period for the entirety of a ‘converted’ Roth IRA.
5-Year minimum holding period before withdrawing investment returns. N/A N/A Yes
Withdrawals taken after age 59 ½ Yes Yes Yes
Withdrawals after quitting your job in the calendar year of your 55th birthday Yes N/A N/A
Immediate Annuity: IRC 72(t) SEPP – Substantially Equal Periodic Payments Yes, but you must terminate employment first. Yes, anytime. Penalty-free but subject to income tax. Yes, anytime. Penalty-free but subject to income tax.
Payments on Death Yes Yes Yes
Disability Yes, if “Permanent” (consult a tax lawyer). Same Same
Medical Expenses Medical expenses paid beyond 7.5% of your AGI Same Same
Health Care Premiums N/A Health Care Premium payments, if:1) Distributions taken no sooner than 12wks after unemployment and terminating no later than 60 days after starting a new job.2) Allowed in the Calendar Year of unemployment to follow-on CY only. Same as “traditional” IRA
One-time tax-free transfer to Health Savings Acct. N/A Up to $5800 (family)/$2900 (self)(See IRB 2008-25). N/A
“Qualified” Education Expenses N/A Tuition, fees, supplies, equipment.- Room&Board if >1/2 time student.- Withdrawals can be for self, spouse, children, or grandchildren. Penalty free (IRS Notice 97-60).
1st time home purchase, or first ever plan withdrawal after not owning a home for two years. N/A Yes. $10K lifetime limit for home purchase per person (not per retirement account). Same as “traditional” IRA
Mandatory Distributions as a part of a QDRO (divorce) settlement. Yes N/A N/A
Works Cited:
IRB 2008-25.
IRC Section 72(t).
IRC Section 401.
IRC Section 401(k).
IRC Section 408.
IRS Regulation 1.408A, Roth IRA Regulations
Slesnick, Twila. IRAs, 401(k)s & other retirement plans : Taking your money out. 10th ed. Berkeley: Nolo Press, 2011.
IRS Notice 97-60.

 

Eddie served seven years on active duty as a Submariner and holds a Master’s Degree in Personal Finance from the College for Financial Planning. He earned his commission from the Naval Academy in 1993 and is looking forward to earning his retirement both as a Naval Reservist and Federal Employee. He can be reached at ejwills AT 1993 dot USNA dot com.

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Related articles:
Where to put your savings while you’re in the military

 

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Ask your Dad if you should contribute to the Roth TSP.

August 1, 2012 by · 8 Comments

 

 

This guest post is brought to you by Eddie Wills.

My dad just turned 70 ½. It’s a major milestone in the eyes of the IRS, as it marks the calendar year he must begin taking Required Minimum Distributions (RMD’s) every year from his Individual Retirement Account (IRA). To celebrate this major milestone, we threw a big Half-Birthday Party for Dad with half of his friends invited, and 70 ½ candles on the cake.

Ok, Just kidding. Nobody throws a birthday party halfway through a natal year- But my point is, I’m over 40, and I still continue to learn important stuff from Dad.

You see, aside from many things, my parents taught me how to be thrifty. Dad had no college debt in his youth (he graduated from a service academy), he saved regularly throughout his military and private sector careers, and still lives in the same house the family owned some 27 years ago. He did not retire from active duty with a pension, but has a small pension from one of his private sector employers.

In spite of saving diligently for their entire careers, my parents have been in the 15 percent federal tax bracket throughout retirement. That’s not a typo. There are no oddball tax deduction maneuvers going on. Their mortgage is paid off. In even-numbered years Mom and Dad take the standard deduction, and in odd-numbered years they itemize deductions by bunching up charitable contributions and state property tax payments.

Dad enlightened me with this- The revelation that in many cases people drop to a LOWER tax bracket on the day they begin retirement, even if they have done a terrific job of saving. This is possible because retirees can pick and choose what types of assets to draw down first. Some sources of retirement reserves are return of capital, capital gains, and Roth contributions- all of which have zero or little income-tax ramifications. Even when the gains and income are completely taxable, mind you that in 2012 a married couple can make $82,600 of PURE INCOME and still end up in the 15 percent marginal federal tax bracket (after subtracting the standard deduction of $11,900).

So what does this have to do with you and your fellow Military Guide readers? Well, like you, I’m working on earning a military retirement (from the Naval Reserve) and have been putting money in Roth IRA accounts over the years, believing the hype that if I save regularly, I will have this huge retirement war chest nest egg, which will place me in the same or higher tax bracket in my retirement years. The 2012 addition of the Roth TSP option to the Active Duty and FERS retirement systems adds another variable to the equation for Active Duty, Reserve/Guard, and Federal Employees. Nobody wants to get soaked for income taxes in retirement after saving up during all those working years- so the Roth must be the best answer, right?

[Side Note: The TSP is a GREAT deal for feds and active duty. Expenses are rock-bottom, and when you are nearing retirement, the G-fund gives you guaranteed returns equivalent to a 3-year CD combined with the liquidity of a money market fund. There's no other financial product like it available.]

Back to what it has to do with the fatness of your retirement wallet. You need to be armed with proper knowledge to choose between TSP and Roth TSP- The critical questions you must answer now before you make your Roth TSP election are: What is my income tax bracket now, and what will it be when I am retired drawing a pension (and/or other available sources of income)?

Your income level right now is pretty easy to find. Just look at your “Taxable Income” from your last income tax return (Line 43 on Form 1040). Then look at the tax tables to figure out what your ‘marginal’ tax bracket is. This is what it costs you in taxes to earn your next dollar of income, and is also used to calculate the after-tax cost/benefit of contributing to a retirement plan.

Next is your income in retirement. There are two ways to figure this. First, figure out your retirement income ‘floor’ value by looking up the military retirement basic pay tables for the rank/rate/years you will have attained at retirement (Reserves/Guard know how to crunch their equivalent values from reading Nords’ book). Second, figure out your ‘ceiling’ retirement income value by looking at your annual expenses now. I’m oversimplifying a bit, but your retirement income tax bracket will be somewhere between the two values (what you’re guaranteed to receive and what you think you will need as living expenses).

It’s number crunching time. I’m going to use the terms Traditional IRA/Traditional 401k/Traditional TSP interchangeably, and Roth IRA/Roth 401k/Roth TSP interchangeably- Traditional retirement products are given similar IRS treatment with one another, and the three Roth products are given similar IRS treatment with one another.

An “Apples to Apples” comparison (After-Tax dollars in, After-Tax dollars out) of Traditional retirement products to Roth retirement products shows that the Roth option will put more money in the pocket of the retirement saver, IF the saver ends up retiring in a higher tax bracket than the day s/he retires from full-time work. Conversely, in cases where the retiree drops down one or more tax brackets in retirement (like Dad dropping from 25 to 15 percent), the Traditional retirement product is the best option. If your tax bracket does not change from work to retirement, the decision is a wash.

(You can download the spreadsheet here.)

(Nords note:  The green line shows how much income you’d receive from a Roth IRA. It only goes up to 28% because above that tax bracket you’d make too much income to contribute to a Roth IRA.)
(The other lines show how much your income would rise if your retirement tax bracket is lower than your employment tax bracket, or how much your income would drop if your retirement tax bracket is higher. For example the Roth IRA contributions result in $1.83 income/year in retirement for every dollar contributed during employment. If you made conventional IRA contributions in the 25% tax bracket and then dropped to the 10% or 15% brackets in retirement, the conventional IRA would have resulted in $2.07-$2.20/year in retirement. If you’d risen to the 28% tax bracket in retirement, however, your higher taxes would leave you with only $1.76/year.)

Also note that these conclusions hold true for anything with a 5-year or greater holding period and reasonably assumed rates of return (I used 8 percent assumed return in this set of calculations). You’re free to download the spreadsheet and plug in rates, holding periods, and brackets as you wish.

Variables to consider:

1) Active Duty or Federal Employees deployed to a tax-free combat zone. If you’re in this situation, take the tax-free income portion of your compensation and MAXIMIZE your contribution to the Roth TSP (plus Individual Roth IRA, if eligible). Tax-free money goes in, tax-free compounding, tax-free qualified withdrawals in retirement- This is the Holy Grail of tax-advantaged retirement saving!

2) Active Duty, no tax-free pay earned. At the time of this writing, there is no federal matching contribution to your TSP salary deferrals. Do the same analysis (tax brackets now vs. in retirement) to elect Roth- or Traditional TSP.

3) Ex-military in a Federal Employee ‘Bridge Career’. The FERS employer TSP ‘match’ goes in to a ‘Traditional’ TSP no matter which option you choose for your salary deferrals. Make your Roth versus Traditional TSP election based on anticipated working-vs.-retired tax brackets.

4) Ex-military, now working for Private Sector employer. Same analysis (will your tax bracket be higher or lower) applies to the decision to elect a Traditional 401k or Roth 401k for salary deferrals.

5) Ex-military, with other earned income. Same as above decision basis to choose between Traditional IRA or Roth IRA contributions (assuming you meet Roth IRA income eligibility requirements).

Discuss amongst yourselves…

Eddie served seven years on active duty as a Submariner and holds a Master’s Degree in Personal Finance from the College for Financial Planning. He earned his Commission from the Naval Academy in 1993 where, among other dubious distinctions, he was compelled to tell jokes to Rob Aeschbach every Friday at noon. Eddie is looking forward to earning his retirement both as a Naval Reservist and Federal Employee. He can be reached at ejwills AT 1993 dot USNA dot com.

Reminder: This is a guest post. Please be polite, or the comments moderator will kick in.

 

Related articles:
The TSP matches contributions for military members?
If I only knew then what I know now
Roth TSP: 7 May, but later for military
Is the Roth Thrift Savings Plan right for you?
Where to put your savings while you’re in the military

 

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Starting your kid’s Roth IRA

March 26, 2012 by · 4 Comments

 

Earlier this month, noted CFP & military veteran Jeff Rose was running a financial seminar with a roomful of college students. These seniors are graduating in a couple of months to (hopefully) earn the big bucks for their retirement accounts. He wanted to suggest ways to start on their own financial independence, so he asked them who knew what a Roth IRA was.

Over 50 young adults in the room. Not a single hand went up.

Jeff’s started a Roth IRA movement to call attention to this awareness problem. Over 135 personal-finance bloggers are hitting the subject today. I can’t wait to see how the blog statistics turn out.

I’m blogging for grownups here, so I’m not going to tell you how to start your Roth IRA. You probably already know about Roth IRAs, and I hope you already have one. If you’re just starting your military career, then please save the money and start your Roth IRA soon.  (Even if you already have a military retirement, you can still fund an IRA with earned income from a bridge career.)  If you’ve been deployed to a cave or living underwater for the last few months, then you still have a couple of weeks left to make your 2011 Roth IRA contribution. If you have other questions, then Bankrate is hosting a Tweetchat today at 3 PM EST. (Hashtags are #dlrchat and #RothIRAMovement.) Or post a comment here, or send me a private “Contact me” note.

I’m going to focus on a niche aspect of Roth IRAs. If I’m blogging about Roth IRAs with over 135 140 other bloggers, at least 134 of whom have more traffic than I do (for now!) then I’m not going to get much traction with “How to start your Roth IRA“. I’m also not planning to talk about incredibly complex topics like “Can you get rich buying rental property with your Roth IRA?“.  (Hint: No.)  Instead, I’m going to discuss helping your kid start their Roth IRA.

Here’s the problem. You want to help your kid save for college, or at least help them move out of your house and into their first apartment. You want your kid to put their earned income somewhere that belongs to them, somewhere safe where it can begin compounding away, and somewhere that it’s not burning a hole in their pocket every time they walk by an electronics store.

You could persuade them to contribute that money to a 529 college savings account, but what if they get a scholarship or don’t want to go to college? You could put that money in their savings or in a taxable account with a mutual-fund company, but then they pay might have to pay taxes on the earnings. (Their investment assets also count against them if they’re seeking financial aid for college.) You could help them open their first checking account or show them how to buy a CD, but those won’t solve the problem of sequestering the money away from their next spending spree.

Ah, but a Roth IRA solves nearly all of those problems. Once your kid starts earning their own income, they can put it away in an account that could compound for decades. It’s safer than their piggy bank. You don’t have to pay taxes on the earnings. It’s not restricted to college expenses, and it won’t count against their federal financial aid. It’s also hard for them to blow it on lifestyle while they’re still developing their delayed-gratification skills.

 

So what’s the minimum age for opening a Roth IRA?

There isn’t one. Your kid just has to have earned income and find a financial company willing to be the custodian. You, their parent or guardian, will probably have to sub-custody the Roth IRA account for them until they turn age 18.

If your six-month-old baby lands a gig as a photographer’s model, then their earned income can go straight into a Roth IRA. If your eight-year-old washes cars in the neighborhood, and then mows neighbor’s lawns and walks their dogs, they can open a Roth IRA. When your 14-year-old comes home with their state work permit, all starry-eyed with the anticipation of asking “Would you like fries with that?” then they can open a Roth IRA with their first paycheck.

It’s surprising how fast the money can add up. If a 12-year-old kid earns $5/hour for five hours/week, that’s at least $1250/year. That’s for simple projects like car washing, yardwork, home maintenance, and house painting (and writing guest posts for blogs). Not every child will have this focus or desire, but some of them will willingly get into the habit. The IRS will probably not send in the audit team if you pay your child $10/hour, as long as you properly declare the earned income.

First comes the federal paperwork. Page 10 of IRS Pub 15 (Circular E) says “Payments for the services of a child under age 18 who works for her parent in a trade or business are not subject to Social Security or Medicare taxes if the trade or business is a sole proprietorship or a partnership in which each partner is a parent of the child. If these services are for work other than in a trade or business, such as domestic work in the parent’s private home, they are not subject to Social Security and Medicare taxes until the child reaches age 21. However, see covered services of a child or spouse later. Payments for the services of a child under age 21 who works for his or her parent whether or not in a trade or business are not subject to federal unemployment (FUTA) tax. Although not subject to FUTA tax, the wages of a child may be subject to income tax withholding.” Good– no tax for SS, Medicare, or unemployment insurance.

Withholding is a different issue. IRS Pub 505 may require withholding, but crunching through form W-4 allowances and the withholding tables will probably show that the amount to be withheld is… $0. In other words your child may not have to pay any federal taxes on their earned income. I can’t make any blanket recommendations about withholding or taxes because each child’s earned and unearned (investment) income may trigger different tax situations.

I strongly recommend that you research your state and locality withholding and tax rules as well. You’re probably not going to have to withhold taxes from their earnings, but their earned income may trigger taxes.

 

So where do your kids open their first Roth account?

I phoned several of the largest investment companies to see whether they were familiar with the subject. The only company that gave me an argument was Fidelity, and they’ve been this way for years. Fidelity will not open a Roth IRA for a child under the age of 18. They are unable to articulate a rationale (other than “Fidelity policy and IRS tax concerns”) but they’ve been that way since our daughter tried to open a Roth IRA with them in 2006. In fact it took me two tries to convince the customer-service representative that this “No Roth IRAs for minors” rule was Fidelity’s policy and not federal law.

Sharebuilder won’t open a Roth IRA for a minor, even if the parent/guardian is the subcustodian. This seems ironic for a company whose phone answering system announces “Hey, thanks for calling!” and plays reggae Muzak on the hold line. If they’re trying to appeal to a young, hip crowd then I guess they only want the ones older than age 18.

Schwab, TD Ameritrade, Vanguard, and T. Rowe Price will all set up Roth accounts for minors (as long as the parent/guardian is subcustodian). Most of them will start the application over a website and finish it with an additional form. Some are more flexible than others (TD Ameritrade has no minimum deposit while Schwab only requires $100). T. Rowe Price will set up a Roth IRA for as little as a $100/month contribution. Vanguard has the nation’s lowest mutual-fund company expense ratios but requires a $1000 minimum deposit for most accounts. Minimum deposits are no problem if your child has a high earned income, but if not then you may want to wait until January-March to make contributions across two different tax years at the same time.

Once your child turns age 18 (and is considered legally old enough to sign a contract) then they can apply to the company to have the sub-custodian removed from the account. No matter where you start a Roth IRA for a minor, you’re free to change to a new fund company once they turn age 18. This allows you to consolidate your kid’s accounts or other family accounts with one company.

Keep in mind that you should only help your kid(s) with Roth IRAs after your own retirement finances are on track. Kids can get college financial aid (or work for it) while nobody will lend you money for retirement. You also have to know your kid, because the Roth IRA becomes their property when they turn 18 years old. If they really wanted to, and if they exerted substantial personal effort, then they could cash in the IRA (paying the appropriate taxes & penalties) and buy a really sweet party weekend. If they want to make a penalty-free withdrawal of all their contributions and go buy themselves a really hot ride, then they can do that too. (Our college daughter is reading this post and thinking “Wait, what?!?”…)  It’s always been their money, and once they turn age 18 then they can take control over it.

 

Related articles:
Check the Roth IRA Movement list of the other 140+ personal-finance bloggers.  It should be live by the time this post is up, and it’ll cover all sorts of Roth IRA subjects.
A second Roth IRA Movement list of bloggers
Pay your kids to fund their own Roth IRA
Forbes: Make your kid rich with a Roth IRA

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Is the Roth Thrift Savings Plan right for you?

March 19, 2012 by · 15 Comments

The Thrift Savings Plan “Highlights” newsletter came out last month with an update on the annual expenses of their six type of index funds: 0.025%. Two-and-a-half basis points. 25 cents of expenses for every thousand dollars in your TSP account.

As far as I’ve been able to learn, that’s America’s cheapest collection of tax-deferred passive index funds. Not even Vanguard can reach that low an expense ratio.

However the TSP’s costs are already very low because they don’t have the expenses of a traditional index fund. They’re one of the world’s largest collections of tax-deferred investment funds, so their fixed expenses are already a smaller percentage of their total assets than other funds. Their variable expenses are a lot lower– have you ever seen a TSP ad in a magazine next to a Vanguard spread? Their agency has very few customer service staff (compared to fund companies) because they’re not trying to close a sale. TSP employees are paid by the federal government, although admittedly most of Vanguard’s employees aren’t getting rich off their customers either.

True, the TSP’s actual costs are a little higher than 0.025%. Management is offsetting some of the TSP’s expenses from the forfeiture of contributions of participants who left the TSP before they’d actually vested in it. Other offsets come from fees paid by participants who have taken out loans. (Otherwise, taking out a TSP loan is usually not a good idea.) These forfeitures and fees go back into the TSP funds to reduce their expenses.

Now, in addition to their index funds, the TSP is about to start offering a Roth TSP option.

11 April update:  the Roth TSP will launch on 7 May 2012, with delays for some services.  More information here from Stephen Losey of the Federal times.

We don’t know when the Roth TSP will start.

For the last year, the TSP has been advertising their Roth TSP feature. Last year it was delayed to first quarter of 2012. We’re almost through the first quarter, and the latest rumor is that it’s either going to start next month or be delayed for several more months. I’ll post the start date as soon as it’s official. If you’re a servicemember then you’ll probably see the clouds part and hear the trumpets sound the fanfare at the same time I do. Feel free to link the announcement in the comments.

 

Should you care about the Roth TSP? Heck, yes. If you’re receiving a military paycheck, the Roth TSP is a good deal.

Here’s the existing situation: The vast majority of military servicemembers can contribute up to $17,000 of their pay to the TSP. (See the disclaimer at the end of this post.) Contributions are tax-deferred, which means that they’re untaxed when you make them. You pay regular income tax when you withdraw your TSP funds later– for most participants, “later” is after age 59½. You have to start TSP withdrawals by the time you turn 70½, either through an annuity or a “required minimum distribution” system.

Problems with today’s TSP:

1. Most military compensation is already lightly taxed. Military base pay is lower than its civilian equivalent because total compensation includes tax-free allowances and other non-cash benefits. For most of the military, contributing tax-free to the TSP now doesn’t actually save very much in taxes. Of course you’d want to revisit this situation when you’re promoted to E-7 or O-4.

2. TSP funds are hard to reach. (Admittedly for a few of us this is an “advantage”.) The vast majority of participants can’t touch the money (without penalties) until age 59½. There are ways to reach it earlier, but they require considerable planning: either (1) rolling TSP funds into a conventional IRA for a 72(t) “substantially equal periodic payments” distribution, or (2) converting that rollover IRA to a Roth IRA and waiting five years to be able to withdraw its contributions. What this access challenge means to the rest of us is that practical financial independence depends on being able to tap a separate Roth IRA (contributions only) or other taxable accounts before being eligible to touch the TSP.

3. Military pensions. (A “problem”?!?) If you’re receiving a military pension, then every year of your retirement you’re going to be in at least the federal 10% personal income tax bracket. TSP contributions are tax-deferred, which means that when you start withdrawing them they’re taxed as personal income. Since you’re already receiving a pension, the TSP income is immediately subject to the federal 10%-15% income-tax bracket. It’s quite possible that, even if today’s tax rates stay the same, your future TSP withdrawals will be more heavily taxed than the tax you avoided with today’s contributions.

4. The TSP (and conventional IRAs) are subject to required minimum distributions. If you have a long military career with high earnings, or high earnings outside the military, then in retirement you have a tax-management challenge with the RMDs from the TSP and conventional IRAs.

5. Political risk: most analysts expect future federal tax rates to rise. It might be better to pay the taxes now, when you make the Roth contribution, rather than later when you take a TSP withdrawal. Admittedly it’s exceedingly difficult to plan your financial life around political risk… maybe even futile.

Solutions from the Roth TSP:

1. You pay taxes up front on a Roth TSP contribution, possibly at the lowest rates you’ll see in your lifetime.

2.-4. The biggest advantage of the Roth TSP is that you retain control over your withdrawals. You can withdraw your Roth TSP contributions anytime. You never have to take minimum distributions. *  After age 59½ (and after five years since your first contribution) your Roth TSP distributions are not taxed.

* (Thanks for keeping me honest, guys.  I thought I’d read this in one of the TSP references but I may be wrong.  I’m re-checking my references.  I’ll update this post [with the reference] when I have the full answer.  See my correction below.)  

If you’re earning pay in a combat zone then you’re even able to contribute that money to the Roth TSP, which means that both the contributions and the earnings will never be taxed. Better yet, if you’re old enough (age 50) then you can make catch-up contributions to the Roth TSP while you’re in the combat zone.

5. Admittedly there’s still an element of political risk: Congress could change the Roth IRA rules to require taxable minimum distributions, which would raise a lot of tax revenue.  (Thanks to Anjali for pointing out my confusing wording on this one!)  Personally I think the Boomers have the votes (and the campaign contributions) to protect today’s Roth IRA rules. “Fixing” the country’s finances will probably come from a compromise of heavier salary taxes and lower tax thresholds (“means testing”) on retiree incomes.

Luckily you can even hedge the political risk. The Roth TSP is not a binary all-or-nothing decision. You can elect to contribute up to $17,000 to the TSP and nothing to the Roth TSP, or nothing to the TSP and $17,000 to the Roth TSP, or some split between the two. If you’re worried about the tax rules changing before your game is over then you could split your contributions at $8500 to each.

Keep in mind that the Roth TSP is still a completely separate program from your personal IRA. You can always start a conventional IRA with as much as $5000 in annual contributions, and if you’re under the income limits then you can contribute to a Roth IRA. Even if you’re subject to the Roth IRA’s contribution limits you can still contribute to a conventional IRA and immediately convert it to a Roth IRA using the “backdoor Roth IRA conversion” loophole.

The Roth TSP is a big step forward in military compensation, and if I was still wearing a uniform then I’d be all over it. Take a look at the TSP’s website to make sure you understand the details, and be ready to start your contributions as soon as the TSP is ready to take them.

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23 March 2012 error correction:

I gained the mistaken impression (from the Roth TSP video on the TSP’s website) that Roth TSP contributions could be withdrawn at any time. I was wrong, and indeed there’s no other document on the TSP’s website to suggest that.

It turns out that TSP Roth contributions are part of a group of accounts known as “designated Roth accounts”. A designated Roth account is “a separate account in a 401(k)… to which an employer allocates an employee’s designated Roth contributions and their gains and losses. The employer must separately account for all contributions, gains and losses to this designated Roth account until this account balance is completely distributed.”

I was confusing the features of a Roth TSP (a designated Roth account) with a Roth IRA. To clear that up, I checked with J.J. Montanaro at USAA.  He says:

I think you may be “mixing and matching”–but Roth IRA and Designated Roth 401(k) are definitely different. Roth TSP is what the IRS calls a “designated Roth account”–contributions are not treated the same as Roth IRA (you can’t withdraw at anytime without taxes or penalties) and withdrawals are limited to the same rules as a Traditional TSP or 401(k). Here’s a good Roth designated account FAQ at the IRS website.

The IRS’ website FAQ on designated accounts includes this Q&A:

Q:  Since I make designated Roth contributions from after-tax income, can I make tax-free withdrawals from my designated Roth account at any time?

A:  No, the same restrictions on withdrawals that apply to pre-tax elective contributions also apply to designated Roth contributions. If your plan permits distributions from accounts because of hardship, you may choose to receive a hardship distribution from your designated Roth account. The hardship distribution will consist of a pro-rata share of earnings and basis and the earnings portion will be included in gross income unless you have had the designated Roth account for 5 years and are either disabled or over age 59½.

J.J. continues:

Roth TSP is subject to RMDs… however, the easy workaround is to rollover to a Roth IRA well before you get to that age. This is referenced in a lot of places, but page 18 of IRS Publication 560 is one place and here’s an IRS Roth Comparison chart which includes the info.

For example, this TSP bulletin says: “The law does allow separated participants… to withdraw regular TSP balances and transfer them to a Roth IRA.”

Once again, mea culpa. I hope this clears things up (or makes them as clear as they can get) and helps with your transition planning. Please post more questions here, and if I don’t know the answers then at least I know where to find out!

——————————————————————————————-

Disclaimer: I’ve simplified this post’s explanations of the rules for contributions to and distributions from the TSP, the Roth TSP, and IRAs. The simplified explanation applies to the vast majority of people eligible for these accounts, but there are qualifiers and exceptions. For example, withdrawing Roth IRA earnings after age 59½ is only tax-free if it’s been at least five years since January 1 of the year that the first Roth IRA contribution was made. In addition, just about every one of the above situations has a loophole– especially for duty in a combat zone, permanent disability or death, or for catch-up contributions after age 50.

If I’d added those qualifiers & exceptions to every sentence of the above post, the parentheses and asterisks and footnotes would make the text unreadable. Before you make your own decision, read the (nearly unreadable) text in the source documents that I’ve linked. Consult a tax professional to work out any confusion or details. More free advice is always available at Early-Retirement.org, or ask your question here in the comments.

Related articles:
TSP tips and trivia
TSP annuity options
TSP withdrawal options
Where to put your savings while you’re in the military
http://thefinancebuff.com/most-tsp-participiants-should-switch-to-the-roth-tsp.html
http://paycheck-chronicles.military.com/2012/02/23/roth-tsp-its-coming/

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Trends in personal finances

July 20, 2011 by · 1 Comment

The blog went over 20,000 hits last week– thanks! It took over six months to get the first 10,000 hits, and only three months to do it again. This month is on track to set yet another new high, and if the trend continues then 30,000 hits will happen in September.

I’ve read a number of interesting financial and retirement articles lately.

First, the Dividend Growth Investor blog is still a favorite. I’ve tried nearly all styles of investing and this one holds my interest. Unfortunately the rest of the investor herd is beginning to appreciate dividend investing too, so that may start driving up the sector’s prices (and driving down the dividends).

In a recent article, they point out that even dividend investing is risky when you’re not properly diversified. If you’re interested in this strategy, too, then keep it to a fraction of your total portfolio and rebalance when it gets too far out of proportion. You may decide to invest in a dividend mutual fund or an ETF (like the Dow Dividend ETF, DVY) with as much as 25% of your portfolio. If you’re choosing individual dividend-paying stocks, though, it’s probably wiser to hold that allocation down below 20% and to strive to spread it among 30-40 stocks.

Blogs like Dividend Growth Investor can appeal to active investors who also make the time for their education & analysis. (Of course others may see this as a terrible way to spend a life.  I’m inclined to agree.)  However the last few years have also seen a backlash against investing, especially when many investors watched their “diversified” portfolios go down across all sectors. (It can happen to the most diversified of us.) More than two years after the market lows, some are still paralyzed by the recession’s trauma. They have yet to face the seemingly impossible tasks of choosing an asset allocation and putting their savings into it.

Next, two startup companies are hoping to capitalize on that paranoia and fear. Betterment and Flat-Fee Portfolios were recently profiled in a New York Times article describing their approach to investors who want to keep it simple but who want help getting started.

Betterment has dumbed down simplified asset allocation to its lowest common denominator with a two-step process:

  1. “How much risk do you want to take?”
  2. “OK, thanks, here’s your asset allocation!”

They implement your risk profile with exchange-traded funds, and you don’t have to be bothered with the details.

Flat-Fee Portfolios offers three portfolio choices for one price. Their options include actively managed funds and an attempt to sidestep market whiplash, but they earn all their fees from their investors. There are no kickbacks “soft-dollar partnerships” with other fund companies and no conflicts of interest. Give them your money, pay their fees, and they’ll keep you informed.

Unfortunately “simple” and “helpful” are not the same as “cheap”, and you pay a price for blissful ignorance. Betterment doesn’t require minimum balances (as many large firms do) but a small investor will pay a whopping 0.9%/year for their services.  (That’s on top of the trading commissions and expenses of the funds they invest in.)  Flat-Fee Portfolios charges $199/month, which only approaches parity with the rest of the financial industry’s fees if your portfolio is at least $200K.  However a do-it-yourself tax-efficient investor could easily have a portfolio over $1.5M before their monthly fund expenses reached $199.

How can a busy servicemember invest without paying those fees? First, max out your Thrift Savings Plan contributions. If you’re hesitant what asset allocation to use then pick a lifestyle (“L”) fund closest to the date when you see yourself retiring. Next, max out your Roth IRA contributions with a similar low-cost index target fund from one of the big firms like Vanguard, Fidelity, or USAA.  (You can even move before-tax money from a conventional IRA into the TSP, and in 2012 you’ll be able to contribute to the Roth version of the TSP.) Finally, max out your savings in taxable accounts with more low-cost target funds or index funds. Small investors may have to start with higher expense ratios or annual fees in their IRAs and taxable accounts, but putting the bulk of your savings in the low-cost TSP will more than make up for that. After a few years of Roth IRA contributions those charges will stop. Among these choices, it’s possible for an investor’s total portfolio expenses to drop below 0.2%/year.

Personally I’d never become a customer of Betterment or Flat-Fee Portfolios, but they serve a need. (One marketing axiom is “Never underestimate the busyness or ignorance of the American consumer.”) I’m not sure their revenue model will find enough of those customers to make them profitable, yet they’re certainly tapping into powerful emotions of investor psychology that affect our savings & portfolio decisions.

Finally, is there a better way to overcome the fear of analysis paralysis? Sure, just like training for combat deployments: focus on the aspects that you can control and minimize the risks of everything else. This Smart Money article points out that most investors spend too much time worrying about macroscopic factors which we “little guys” have little control over: the world economy, government programs, the markets, and random lightning strikes. Instead of waiting for those problems to “go away”, work on the things you can take charge of: setting a budget, paying off debt, saving as much as you possibly can, controlling asset allocation and diversification risk, and minimizing investment expenses. Once you’ve done the best you can with what you have, then go live your life.

In the next post we’ll cover a few more technical and social trends of retirement.

Related articles:
So where should I invest my money now?!?
Saving base pay and promotion raises
Where to put your savings while you’re in the military
Simple ways to start saving
Start saving early

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Market volatility during retirement

May 5, 2011 by · 1 Comment

In an earlier post we discussed how to cope with market volatility while investing for retirement.  The financial part of this answer is straightforward, but dealing with the emotional aspect is hard.

One of the advantages of working for a paycheck is that you’re able to buy investments from your pay. If the market goes down, then you buy more investments. As Warren Buffett says, “A short quiz: If you plan to eat hamburgers throughout your life… should you wish for higher or lower prices for beef?”

In retirement, you’re not bringing home a paycheck anymore: your assets have to supply your income. Not only that, but they have to grow so that your income rises with inflation, or you must have enough assets that you can’t outlive the principal. If the market goes down then the size of your investment portfolio usually drops with it. Even worse, your income may drop too.

In the earlier post I mentioned that spouse and I have experienced extreme volatility three times: twice while we were working and once in retirement. We survived all three in better financial condition than we started them, but the third experience had a new emotional impact that changed our views on market volatility during retirement. We’ve also had experiences with other family members that changed our perception on how to manage their finances too.

However this really isn’t about spouse & me or our investments. It’s about the different choices to be made during the “distribution” phase of managing a retirement portfolio. Talking about our portfolio is just a way to offer specific examples.

We survived the 2008-09 recession without cutting our spending. Today our retirement portfolio is back ahead of our “needs”. We’re still 20% below the ridiculous highs of 2007, but we have enough money to live our beach-bum surfer-dude lifestyle for the rest of our days. We also know that we can handle some volatility, so for now we’re staying with our four stock asset classes and we’re not investing our retirement money in bonds. Our military pensions are the equivalent of bonds, so we usually keep over 90% of our retirement portfolio in stocks.

One of the reasons we’re still so aggressive in our investing is that we reduced our expenses over the last three years– we refinanced our home mortgage and dropped our payments by over 25%. We’ll play much better defense in the next bear market. We won’t have to tap into our TSP and Roth IRAs anytime soon so they can grow tax-deferred indefinitely, helping us self-insure for long-term care. We might make our daughter a very happy heiress in 50 or 60 years, or we could give it away to charity. Or we could have one heck of a world cruise.

However since the Great Recession we also don’t hesitate to “take a little off the table”. When one of our four stock asset classes gets to be more than 25% of our portfolio, we’re selling it back down to 22% instead of seeing if it’ll shoot for 30%. If all four are heading for 25% then we might sell a little from one of the leaders to raise our cash to 10%, perhaps offsetting the capital gains by selling whatever other asset shares have lost some value. This is the equivalent of a worker doubling the size of their emergency fund in case of a layoff.

These days we don’t take any risk with our daughter’s college fund. (You’re welcome, honey!) We took substantial equity risks over 10 years ago, but as she got closer to high school her college fund moved more into cash. Today it’s in CDs, I bonds, and a few leftover 1990s EE bonds. She starts her sophomore year in a few months and we can’t mess around with that money, no matter how attractive the ZipCar IPO seems to be.

In our other generation, my father is expecting to spend the rest of his life in a long-term care facility. Those expenses average at least $75K/year and could easily rise by 10%/year. He still has pension income and long-term care insurance, but he can’t put up with much equity volatility. His retirement portfolio started 2011 at 85% stocks because he was living on his pension income and spending very little money. However this week he’s selling his Fidelity fund investments in Magellan  and International Value to put the money in CDs. Both of his investments in those funds still have losses from 2008-09 so he’ll sell some of his other stock shares to offset the mutual fund’s losses with the stock’s capital gains. Over the next year or two (while he’s receiving funds from his long-term care insurance policy), his asset allocation will drop to 50% stocks and his cash allocation will rise to 30%. When his long-term care insurance runs out in a few years, he’ll be over 50% cash and 30% bonds. He’ll be able to ride out market surprises without having to worry about permanent losses.

Again, these are just examples of our choices. During the recession many early retirees did nothing at all– their diversified stock dividends dropped a bit but they had enough cash in savings to make up for the lower dividend income. Now that the markets are rising and companies are raising their dividends again, the investors are replenishing their cash savings. A few retirees have their retirement portfolio in balanced mutual funds like Vanguard’s Wellesley.  Although the markets whipsawed both stocks and bonds, Wellesley managed to damp out the volatility and keep its distributions almost constant. Today it’s heading for new highs.

Some retirees continued to spend their portfolio income and even dipped into the principal, feeling comfortable that the market’s long-term averages would give their portfolios enough time to recover. Others cut back their spending or even thought about part-time employment.

I’m surprised at how much my attitude toward volatility has changed in the last few years. I’m still a very active investor but I did not enjoy having to look at the shrinking remains of our portfolio, let alone explain our performance to my spouse. Knowing what you have and forecasting what’s next is one thing– feeling good about it is quite different. If you’re reaching the end of your working years, then be ready for your own volatility tolerance to become more conservative. Reduce your asset allocation to stocks, or raise your allocation to cash, or even (if you’re not getting a pension) consider annuitizing a part of your income.

No matter what you decide to do, think through how you’ll feel and what you’ll want to do if your portfolio drops in value by 30%. It’ll help you get through the experience with a little less pain and a lot less panic.

If you went through the Great Recession as a retiree, how did you handle the volatility? Share your experiences in the comments. Thanks!

Related articles:
Retirement Income Redesigned: Master Plans for Distribution: An Adviser’s Guide for Funding Boomers’ Best Years
This 2006 book might be available through your local library. It’s a great series of articles on how financial advisers try to prepare their clients for retirement volatility. If you’re approaching retirement then it’ll give you more ideas on how to design your own distributions.
Asset allocation considerations for a military pension

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So where should I invest my money now?!?

May 2, 2011 by · 7 Comments

Cherie asked a very pertinent question in the TSP post:

 I joined the Navy in 2002 and contributed to TSP until I got out 5 years later. Since I have gotten out I have lost over 1/2 of the money in my TSP. Should I just leave it there and let it do its thing or should I take what is left and roll into a Roth IRA? I’m only 28 so figured that leaving it alone would be ok but just not very confident in the markets anymore and want to make sure I am doing the right thing with my money.

Thanks for your comment!

One of the world’s most frustrating things is watching an investment lose money yet not knowing where else (and “when”) you could have put it. You might not only lack the knowledge, experience, or time to do something about it– there might very well be no place left to hide from a bear market. Spouse and I know what it feels like. During the “Black Monday” of 1987 we finished the day over 20% poorer– in one freakin’ day. In 2001-02 we watched our portfolio melt down by 40% of its value like an ice cube on a Hawaii sidewalk, and nothing we did seemed to make the slightest difference. During early 2009, our portfolio was down over 50% from its 2007 highs. I did a lot of research back in 2008-09, and I know there was no place to hide.

When you left the military in 2007, your TSP was probably at an all-time high. It was certainly at least 20% above the market’s long-term performance levels, and maybe even 40% higher.

One comfort we could count on through Black Monday and 2001-02 was that we still had our military careers. We kept saving for retirement, confident that we’d be buying our next few months of investments on sale. But it was pretty nerve-wracking to retire during the summer of the 2002 market, knowing that I wouldn’t have those steady paychecks to invest anymore. It was even more exasperating watching our portfolio hit its 2009 low. Intellectually, I’d done the math and knew that we could survive. Our portfolio would recover. We wouldn’t even need to cut expenses, let alone look for jobs. But all that academic research & analysis sure didn’t make me feel better, especially the parts where I had to explain my “investor logic” to my spouse. You’re seeing the same issues in your TSP statements.

Another comfort (such as it was) during all of those times was having a plan: we’d done a lot of reading after 1987, and we’d created our asset-allocation plan. We wanted to invest as much as we could in high-quality stock funds with low expenses for at least the next 15 years, and maybe the rest of our lives. We knew that our retirement portfolio would be very volatile but that after 10-20 years its returns would probably beat the averages of bond portfolios, real estate, and commodities. Once again the problem with that research is living through a bear market’s downward volatility. (Nobody complains about a bull market’s upward volatility). It’s a terrible feeling to watch your investments lose so much value, but it’s even more painful to have to look at them while waiting for them to recover. Did you read the right books, and understand them? Was your analysis correct? Did you miss something? Did you make a math mistake? Did you choose the right decisions? Will this portfolio make money ever again?!?

Human psychology magnifies this pain. We don’t watch the market go to new highs and think “Well, it’s 30% above its long-term average, but we don’t really own any of those gains unless we cash out. Even then we’d have to pay taxes. Besides, if we cashed out then we’d have to time things absolutely perfectly, both at the top and again at the bottom, or else we’d miss out on more long-term gains. And when it goes down then it could drop 30%-40% below the long-term average for a few years, so timing is extremely hard and usually wrong. Cool. Let’s go surfing.”  Nope. If you’re like me, you’re thinking “Party!!!!” “Golly, I might be able to retire early!”  Mentally and emotionally you’ve decided that you already own that money, even though it’s still invested in a volatile asset.

When the inevitable “reversion to the mean” occurs, the new bear market almost always overdoes it and plummets below the averages for months. Again our emotional human psychology makes this far worse. We don’t think “Hey, fire sale on stocks, let’s go buy more!” Instead we mourn our recent losses  (taken from the gains that we didn’t own in the first place) and wonder if we’re ever going to see them again. A few sell out at the bottom, locking in their losses and permanently eliminating their chances to recover. We worry that we’re going to end up working until we die. Life is bleak, and now we have to figure out what else we should invest in.

The key is having a plan before the pain starts.  Most importantly, your plan has to match your personal tolerance for volatility with the market’s inevitable (and seemingly psychotic) behavior. A notorious boxer once said “Everybody has a plan until they get punched in the face.” You need a plan that you can live with while you’re trying to stay conscious and get back up off the canvas.

OK, Cherie, back to your question.

The first two things to decide are what you would do with your TSP assets and when you would do it. At age 28, it sounds like you’re planning to keep saving for retirement. It doesn’t appear that you need to tap into it now for retirement income, so you could leave it in the TSP for at least another 10 years– the “long term”.

It also doesn’t sound as if your asset allocation plan involves any exotic IRA investments. Even if you were investing in assets beyond the traditional stocks & bonds, some portion of your plan probably still includes stocks & bonds– and those portions could be handled by the TSP’s fund choices.

Your long-term goals could still include the TSP’s funds, but now you might be wondering if there’s a better mutual fund or stock or bond. The advertising of the financial industry and the investment magazines certainly makes it seem that way. However the reality is that most of a retirement portfolio’s returns depend on its overall asset allocation. About the only things investors can control are that asset allocation and its expenses.

The TSP’s funds have the world’s cheapest expense ratios.  Their returns are very close to their benchmark index, and they’re passively managed. You can get most of the market’s overall return with very little personal effort. This means you don’t have to worry about investor’s money chasing a hot manager (“inspired” by those magazine articles on “10 Great Funds to Own Now!!”), forcing him to find new investments and making it difficult for him to keep up his long-term record. You don’t have to worry whether that manager will stick to the reasons you bought the fund and stay on the job. You also don’t have to work as hard as Warren Buffett to find your own investments and keep track of their performance. You can focus on the things you’re good at– your career and saving money for retirement– and let the market’s performance return to its long-term averages. For 95% of us investors, passively managed index funds are the best approach. The TSP has the world’s largest (and cheapest) passively managed index funds.

It’s frustrating enough to lose profits (whether you “owned” them in the first place), and it’s even more frustrating when there doesn’t seem to be any place to invest the rest. Your losses over the last four years have included one of the market’s biggest rises and steepest declines since the Great Depression. Every equity fund (and quite a few bond funds) got hammered by the overall market conditions. The vast majority of investment portfolios still haven’t recovered from the 2007 highs and some may not recover for another decade.

Your only consolation may be comparing the performance of the TSP’s funds over the last nine years to the performance of other mutual funds.  After fund expenses, you probably have more money left than most of those other funds would have salvaged by having to pay higher expenses during the same bad market conditions. In other words, it could’ve been uglier and the TSP sucked less than most. But our human investor psychology means that’s not much consolation.

So where do we go from here, and how do we avoid feeling this way again?

One way is to try to change your attitude. (This is hard but worthwhile.) The “good news” is that you’ve come through one of the last century’s most intense investing crucibles. You’ve learned far more about volatility at a far younger age than my generation ever experienced. You can apply that experience in your asset allocation plan. You can decide to put up with the future extremes of volatility because you have time enough to recover before retirement. Instead of obsessing over paper losses, you can focus on the opportunity to buy discounted assets for future gains. The trick with this approach is to not panic and sell out at the bottom of the next bear market.

Another option would be to decide that you don’t want your investing life to be quite so exciting. (Unfortunately this could also make your working life longer.) If you want to reduce the extreme highs of volatility of your portfolio then make sure you’re invested in a diversified variety of assets– stocks, bonds, and CDs/money markets. If you want to reduce the long-term average volatility of your portfolio then invest in lower-volatility assets: more bonds or cash and less stocks. I’d strongly urge you to try to keep investing in a high-equity portfolio as long as you have employment income. You’ll have to find a way to cope with the emotional whiplash (“Well, I’m buying more stocks on sale this month and my portfolio will eventually recover”) but you’ll be maximizing your human capital.

So your first step is to refine your asset allocation plan. You have to find the one that works for you, not the “hot fund” approach. Think about how you’ll feel when your plan punches you in the face, and how you want to deal with those feelings. If your asset allocation plan included 70% stocks and you just don’t want to see that volatility again, then consider reducing that to 60% or even 55%. You’ll give up some long-term gains in exchange for reducing the swings of volatility. You won’t enjoy higher returns over the next decade, but you won’t see nastier drops during bear markets. Raise your asset allocations to bonds or to cash, even though those aren’t very good places to be right now. If inflation takes off (and it’s already stirring) then your bonds may underperform for another year or two. Even your CDs won’t be keeping up. But bonds won’t be oscillating as wildly as the stock market, and CDs won’t lose principal.

In the TSP you may want to reduce your holdings in the C, S, and I funds. They’re good investments to own, particularly the S & I funds, but if you don’t want the volatility roller-coaster then you should own less of them. You might want to buy more bonds in the F fund, although good bonds are just as tough to find these days as stocks. I’d stay away from the G fund– you’re still working and you don’t need to eliminate the risk of loss of principal. If you’re nervous about a layoff then put more cash in your emergency fund.

If you want to put this plan in autopilot, then put your TSP contributions in a life cycle fund.  They’re made up of the TSP’s other five funds but as you approach retirement they’re rebalanced to reduce their volatility (and their risks of loss, but also their returns). For example the L2050 fund  has a higher allocation to the C, S, and I funds, and much higher volatility, than the L2020 fund. The L2020 fund  is mostly invested in the F and G bond funds to minimize volatility and reduce the risk of loss of principal. Depending on how much volatility you want to live with, you might choose the L2030 or L2040 funds. If you’re comfortable knowing that the TSP’s L fund is rebalancing every three months, then that confidence might make you perfectly happy with the L2050 fund.

Keep an eye on the TSP’s plan to start a Roth option in 2012. You might even be able to roll your Roth IRA into the TSP, which would immediately reduce your expense ratios.

For your other tax-deferred accounts (like 401(k)s or 403(b)s), try to find the lowest-cost index funds that they have available to fit your asset allocation, and make sure you maximize your employer’s match. In your taxable accounts, seek out low-cost index funds that fit your allocation plan. These would certainly be Vanguard or perhaps Fidelity funds. They also have lifestyle funds similar to the TSP’s L funds, although with much higher expense ratios.

That’s what should work best for you, Cherie.

What are spouse and I doing in retirement, after our third experience with extreme volatility? I’ll cover that in another post.

Please do us a favor– check in occasionally with an update.  We’d like to know how this is working for you and, more importantly, what lessons you want to pass on to other investors going through the same experience. Thanks!

Related articles:
Tailor your investments to your military pay and your pension
Bogleheads.org on investment allocation
Read the first two subjects in the “Topics” box, starting with “Investment policy statement”
Recommended reading
Try “The Boglehead’s Guide to Investing”, “Work Less, Live More”, and “The Four Pillars of Investing”.  In that order.

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