Combat zone contributions to the Thrift Savings Plan

October 25, 2012 by · 2 Comments

 

 

A reader asks:

“When does it make sense to make tax-exempt TSP contributions (contributions while in a combat zone)?

I already max out my Roth IRA ($5,000) and hit my traditional & Roth TSP contribution limit ($17,000), but I can also contribute an additional $33,000 of tax-exempt combat pay to the TSP. Essentially, I am deciding between investing the funds in a taxable account or making tax-exempt TSP contributions.

If I did not make the tax-exempt TSP contributions, I would put the money into a stock index fund through Vanguard and I’d have to deal with capital gains and dividend taxes. The earnings on the tax-exempt contributions would be taxed upon withdrawal, but the contributions would be distributed tax-free on a pro-rata basis from the taxable and tax-exempt balances. While I’m in a combat zone I’ll probably pay no income taxes, but after that I expect to stay in the 15% bracket.

How does the math work out for this? What are the non-financial considerations? Thanks for your input! I hate capital gains math and the only other articles I’ve found online discuss tax-exempt versus tax-deferred TSP contributions.”

 

First, congratulations on maxing out your contributions to your financial independence! These are really good “problems” to have. I wish we saw that more often.

It looks like you already know that your Roth TSP is still stuck at the $17K limit this year, even if you’re contributing tax-exempt pay. The TSP website says this about Roth TSP contributions: “If you are a member of the uniformed services, you should know that Roth contributions are subject to the elective deferral limit ($17,000 for 2012) even if they are contributed from tax-exempt pay. If you want to contribute tax-exempt pay toward the annual additions limit, you will have to elect traditional contributions for any amount over $17,000.”

Before we dig into all the gory details below, let’s skip to my advice: put half of that $33K into your TSP, the other half into a taxable account like Vanguard, and then go on liberty. You’ll hedge your bets sufficiently to be able to stop optimizing and get on with your life.

Overall I think it makes sense to contribute as much as you can to the Roth TSP, your Roth IRA, and the TSP before putting anything in a taxable account. However one reason that people put money into a taxable account is to have funds available to bridge the gap between the time they stop working and the time they reach the TSP’s penalty-free withdrawal age of 59½. Even before that age you can still withdraw contributions from a Roth IRA penalty-free at any time, and you can withdraw the gains from that Roth IRA before age 59½ with a 72(t) plan. You can also start piling up spending cash in taxable accounts during your later working years, but you can only take advantage of the TSP’s tax-deferred compounding if you contribute early in your military career.

I think the TSP’s low expense ratios make it a compelling investment against even Vanguard. 20 years in the TSP at its 0.025% expense ratio eats up only 0.5% of your principal. 20 years of Vanguard’s 0.06% expense ratio still eats up about 1% of your principal. But it’s typical for even most Vanguard investors to have an overall portfolio expense ratio of about 0.20%, which would eat up about 4% of your principal during two decades.

Even though TSP gains are taxed as income, your tax-exempt contributions reduce your taxable income. A taxable account (like Vanguard) might have lower taxes on its dividends and capital gains, but there’s just no way to predict what tax rates will be in 20 years. It may be safe to assume that capital gains and dividend tax rates will be lower than income tax rates, but at lower incomes the difference in tax rates might not be significant.

I’ve read another dissenting opinion on tax rates– an opinion that favors taxable accounts over the TSP. The theory is that future income tax rates will almost certainly be higher, and that if your income tax rate in retirement will be higher than your current income tax rate then it makes more sense to pay your lower taxes now. For example if you retired from active duty today with a $40,000/year pension then you’re already in the 25% income tax bracket. (In 2012 the 25% bracket begins for single taxpayers at just $35,350 and for married filing jointly taxpayers at $70,700.) At age 70½, when mandatory TSP withdrawals kick in, you’ll quickly be deep into the 25% bracket and maybe even more. If you send today’s excess income to a taxable account instead of the TSP, then it’d be taxed at a lower cap gains/dividends rate. But again I can’t predict what the political or tax situations will be in 20 years.

The usual way around that “dissenting opinion” situation is to roll a portion of your TSP over to a conventional IRA and start doing Roth IRA conversions every year to the top of the 15% income tax bracket. But if you’re single then your active-duty pension may already fill up the 15% bracket, and there’s no additional room for a Roth IRA conversion.

What if you transfer to the Reserves/Guard instead of staying for an active-duty pension? Then when you stop working in your 40s or 50s, you’ll have very low income for a few years. That would give you time to do a TSP rollover to a conventional IRA, followed by a Roth IRA conversion to the top of the 15% tax bracket. When your Reserve pension starts at age 60 you can try to continue with the rollover/conversions, or start withdrawing from your TSP (up to the top of the 15% tax bracket).

So here’s my advice. You should take a military career one obligation at a time, and don’t count on sticking around to retirement. But if you’re abso-freakin’-lutely certain that you’re going to retire from active duty, then stop contributing to the TSP/Roth TSP at $17K. Max out your Roth IRA. Put the extra savings in Vanguard taxable accounts (and keep paying taxes on them) in order to cover your expenses in your 40s and 50s. Know that all military retirees are only ~15% of the total military force, and that includes both active-duty and Reserve/Guard retirements, so you’d have to be certain that you’re one of the ~5%-10% who’d choose to stay for an active-duty pension. Judging from older demographic studies, more Air Force servicemembers retire from active duty than the Army or the Marines. But I think it’s still highly speculative to commit to a full active-duty career if you’re not already at least 15 years into it.

If you think there’s a chance that you’re going to leave active duty for the Reserve/Guard and stop working in your 40s or 50s, then you’ll have plenty of time to roll over your TSP to a conventional IRA and convert it to a Roth. Put your income into the TSP.

If you think you’re going to leave the military completely (and not earn a Reserve/Guard retirement) then again you should put your income into the TSP.

Since these decisions are so fraught with uncertainty, that’s why I recommend the compromise solution: split the difference. Contribute half of your $33K to the TSP, and the other half to Vanguard. That way you’re hedging your bets and you don’t have to make any difficult long-term commitments.

I hope this answers all of your questions. Please let us know what you decide to do!

 

Related articles:
Ask your Dad if you should contribute to the Roth TSP.
The TSP matches contributions for military members?
Is the Roth Thrift Savings Plan right for you?
TSP withdrawal options
TSP annuity options
Where to put your savings while you’re in the military
The Military Wallet: How to Manage Your Thrift Savings Plan Account

 

Does this post help?

Sign up for more free tips on financial independence and military retirement by e-mail, Facebook, or Twitter!

Filed Under: Finances, Military · Tagged With: , , , , , , ,

The TSP matches contributions for military members?

July 25, 2012 by · 6 Comments

This guest post is brought to you by Marine Corps veteran Rob Aeschbach, who’s starting a new career as a personal financial planner.

The Thrift Savings Plan does not offer matching contributions for service members, but the IRS does in some cases. Here is what you need to know about how the government will pay you up to $1,000 if you put away $2,000 for retirement.

If you’re reading this blog then we probably already agree that saving money for retirement is a good thing. Maybe you’re already doing a good job saving, or maybe you’d like to save more but don’t think you can. The point of my post today is to let you know about a part of the income tax system that helps you save, and specifically helps active duty service members due to the nature of the military pay system. And that’s a good thing because the vast majority of people in uniform will never qualify for military retirement pay.

While I think the Thrift Savings Plan (TSP) is an awesome savings vehicle, there is no savings match for military personnel. Some civilian federal employees qualify for matching contributions to the TSP, and many other civilians get an employer savings match for contributions to their 401(k) (while not exactly a 401(k) plan, the TSP mostly looks and acts like one). But recently I looked at the “Credit for Qualified Retirement Savings Contributions”, and I figured that it is effectively a matching contribution for junior service members.

The good news is that the credit is available to you regardless if you put your savings in the TSP or an IRA. The bad news is that there are pretty low maximum income limits to qualify for the tax credit.

That’s where the military pay system comes in. Part of your military pay is non-taxable, specifically your Basic Allowance for Subsistence (BAS), and your Basic Allowance for Housing (BAH). That is good for some reasons (you don’t pay tax on it), but bad for other reasons (your computed retirement pay doesn’t account for BAS and BAH). In this case it is a good thing, since your BAH and BAS don’t count against you in computing your retirement savings credit.

What does this mean for you?  It means that if you are enlisted, or an O-3 or below, you might be able to save more for your retirement than you think.

How does this work?  If during the tax year you made a ‘qualified contribution’ to a retirement account, then you fill out Form 8880 [PDF] with your taxes. A ‘qualified contribution’ generally means a Traditional or Roth IRA, a 401(k), or the TSP. Then use the chart on the form to find out what percentage credit you get based on your income and filing status. The credit is 10%, 20%, or 50% of the first $2,000 that you saved for retirement. The largest credit you can get is $1,000.

Let’s look at an example using 2011 numbers. Sgt Donut is an E-5 stationed at the Pentagon, and he lives with his wife in Northern Virginia (like me), an area with high housing costs. The BAH for a married E-5 in the D.C. area was $1,881 per month in 2011. Base pay (with greater than 4 years of service) was $2,448.30 a month, and monthly BAS was $325.04. So his gross pay in 2011 was $4,654.34 a month, or $55,852.08 annually — but only 53% of that is taxable.

Now take a look at IRS Form 8880 [PDF]. With a taxable income of $29,379.60 and ‘married filing jointly’ status Sgt Donut qualifies for the maximum tax credit. Sgt Donut happened to set his TSP contribution at 10% of base pay, so in 2011 he saved $2,937.96 in the TSP. When he did his taxes he got $1,000 back with his tax refund. Effectively he contributed $1,937.96 to his TSP account and Uncle Sam kicked in another $1,000 for him.

The major downside to this tax credit is how low the income limits are, especially for single people. All of your taxable household income counts toward the limit, including your spouse’s income if you are filing jointly. In my example, Sgt Donut’s wife does not have a job, and they have no other source of income. Other income items that might disqualify you from this credit include dividends and interest on taxable investments, capital gains from the sale of your house, alimony received, or government payments to you for a partial DITY move.

What should you do with that money?  The short answer is to save it, that’s what the credit is for. In Sgt Donut’s case he is only saving 5% of his gross pay for retirement. If Sgt Donut is like most service members, he won’t stay in long enough to earn a military pension, so he should probably be saving more of his pay. What he can do is increase his TSP contribution to 13% of base pay, and decrease his federal income tax withholding by a similar amount; he can do that by claiming more W-4 tax exemptions. Now he’s boosted his retirement savings to 6.8% of his gross pay, but his paycheck stays about the same since he’s receiving the tax credit spread throughout the year, rather than in a refund check at the end of the year.

By planning ahead you can save a little bit more each month for retirement than you thought; for some people that extra, unexpected $1,000 tax refund check might be too tempting to spend rather than save.

Here is a 2011 pay chart that shows what combination of pay grade and service will qualify you for the retirement savings credit, assuming you have no other income (click to enlarge):

Rob Aeschbach served 12 years on active duty in the Marine Corps, and recently retired from the Marine Corps Reserve. He is in the process of starting a new career as a personal financial planner. His email is heath.1578 AT Gmail.com

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

Related articles:
Roth TSP: 7 May, but later for military
TSP tips and trivia
TSP withdrawal options
TSP annuity options

Does this post help?

Sign up for more free tips on financial independence and military retirement by e-mail, Facebook, or Twitter!

Filed Under: Finances, Military · Tagged With: , , , , , , ,

Reader questions about retiring on a military enlisted pension

June 27, 2012 by · 3 Comments

 

 

A reader asks some very good questions:

“I came across your book and am interested in purchasing it, but I have a few questions.

I’m an E-6. I’m married, with no children, and currently only have a retirement savings account via TSP. Is is realistic to assume that someone in my situation can read your book, apply it, and then live off the retirement?

My spouse and I could retire in another country with cheaper cost of living. Would that help my chances, if the above answer is “no?”

I’m really hoping to retire and start my own business– not because I need to, but because I want to. If your book can give me the information I need to make that a reality, then I will gladly purchase it.”

 

Where to find the book

Here are some other book suggestions for “try before you buy“.

First, the blog summarizes most of the book in the ~80 posts between September 2010 and March 2011. There are a few diversions, and the posts don’t have the personal stories of the contributors, but you get a good idea of the contents. (You’re going to have to read the book to get the personal stories.) Scroll through the titles and the opening paragraphs to see what catches your eye.

Second, look up the book at your local library system or on WorldCat.org. It’s in several libraries on Oahu, and it’s in at least 30 other libraries on the Mainland. You might be able to borrow it from a library near you before you make a buying decision.

Finally, see if your military base’s family service center offers free copies of the 4″x5″ 64-page pocket guide. Impact Publications sells these at a very low bulk price for military transition programs and VA service centers to offer to their clients. The pocket guide doesn’t have the contributor’s personal stories and the chapter checklists that are in the full-size book, but it’s another great way to try it before you invest any money in it.

 

Retiring on an enlisted pension

The process of saving for financial independence is fairly straightforward, but the commitment can be difficult. The challenge is to track your spending, figure out what’s important to you, align your spending with your priorities, and make a plan.

It’s realistic, based on the stories I’ve heard from readers and on the process that people are following from the book. However your spending and your savings are important. Save as aggressively as you can in your TSP (and your Roth IRA) and put yourself even further along the path to financial independence. But you don’t have to stop there. Your pay gets a lot better if you finish your college degree and apply for a commission. One course at a time, max out the tuition assistance, and see where it takes you. The worst that will happen is you’ll start your education on the military’s active-duty funding and finish it on your GI Bill.

As you save for retirement, project your pension income against your retirement budget. If it’s not enough then you’ll either need to consider a bridge career, be ready to do some part-time work, or cut back your expenses. I can’t tell you which approach will work best for you, but you’ll know when you’ve crossed the line from “frugal retirement challenge” into “deprivation”. The more you can save on active duty, and the higher your retirement rank, the closer you’ll be to financial independence.

The book includes advice from a Navy Chief nicknamed “Boxkicker” who retired as an E-7 at 20 with only a few thousand in his TSP account. He immediately went back to school on the GI Bill (and its housing stipend) to finish his bachelors’ & masters’ degrees in sports management. His “business” is refereeing community sports leagues and teaching golf. He’s one of at least three other veterans (profiled in the book) who have managed to swing the finances on their pension, with little savings, and with part-time work. It takes a low cost of living and some financial discipline, but it can be done. You’re saving in your TSP, so you have a head start.

 

Retiring overseas

You absolutely can live on a U.S. military pension in another country. We know a number of military retirees who are doing just that.

The two best resources for your own overseas planning are Billy & Akaisha Kaderli’s Retire Early Lifestyle website, and Paul & Vicki Terhorst’s Early Retirement website. Both couples have traveled the world on far less money than you’d expect. They’re experts at living local in Southeast Asia, Latin America, and Europe. You can also try Gary Pierce’s Frugal Retirement Living website. He and his spouse have lived overseas, but they’ve also enjoyed their retirement in America on a boat and in an RV.

 

Starting your own business after the military

I don’t specifically talk about starting your own business in the book. When I first retired, my time & energy went into enjoying retirement. Later I began showing other veterans & families how to achieve financial independence… wait, I guess I did start a business.

If you’re interested in writing then you can read about my experiences in the “Books & publishing” section of the blog. I also talk about earning revenue from the blog, and the sidebar has a whole “Personal finances” section of bloggers who are earning tens of thousands of dollars a year from blogging and advertising. It’s not easy– it’s a job and you might be your toughest boss you’ve ever had– but blogging has a lot of advantages over the office environment. Your earnings are also much more correlated to your effort.

Boxkicker put together his own income in the sports industry. I know of several veterans who have gravitated toward their professional skills, especially training others. As a military retiree, your new business would probably be in the service industry– and in a sector with low startup costs. The advantage of being a military retiree is that you have a safe income to fall back on while you’re growing your business. I’d love to hear from more veterans who’ve used their military experience to start their own businesses and achieve financial independence on their terms. They might not even want to retire from that type of bridge career.

Hope this helps you with your book-buying decision. Whether you decide to borrow or buy it, please let me know what could make it better!

 

Related articles:
Military retirement with low savings
Starting your bridge career after the military
Retiring on multiple streams of income

Does this post help?

Sign up for more free tips on financial independence and military retirement by e-mail, Facebook, or Twitter!

Filed Under: Finances · Tagged With: , , , , , , ,

529 college savings for military families

May 7, 2012 by · 1 Comment

 

 

Thanks to Brandi for her comments on an earlier post, and her question:

My favorite part of the book was all of the personal stories. I can understand how the math works – I’ve calculated all of my future pay raises, estimated rate of savings, and projected retirement benefits to figure out how much I should have saved and how much income I will earn when I exit the military. But I still have a hard time firmly believing that retiring in your 40′s is achievable and that people have done it, which is why the stories are great. Plus, retiring straight out of 20 years of service is not very common, so it’s nice to know I’m not the only “crazy” one out there!

Also, for the blog, I’d love to hear your take on saving for kids’ colleges as a military member. Between GI Bill benefit transfers and an increased likelihood of having the military pay for their school (through ROTC, service academies, or enlisting), it’s hard to decide how much to lock up in a 529. Did you save money in a 529 for your daughter, and if so, what are you doing with the money now?

C’mon and paddle out with us, Brandi, the surfing’s great!

Before figuring out how much to save in a 529, let’s figure out how much to save for college. Regardless of my opinion on the quality difference between community college versus Harvard, there’s a significant financial difference.

 

Save for your retirement first

There are many opinions on how much parents should help their kids with college expenses. It’s a perpetual topic on Early-Retirement.org, and parents’ opinions are affected by their own college experiences.

Conventional financial advice is that you should not sacrifice your retirement savings to pay for your kids’ educations. They can get scholarships and loans for college, but nobody gets those for retirement.

The attitude on saving for early retirement instead of college is more controversial. It depends on how much you feel obligated to subsidize your kids. It may depend on how much support you wish you’d had at their age, and you also have to know your kid. Some will persevere through college no matter what it takes, while others could suck up tens of thousands of dollars with no degree.

 

Who pays for college?

I think that humans (even teenagers) perform better when they have their own assets at risk. The internal motivation is a lot more powerful when it’s their money/labor, not just Mom & Dad’s. It’s probably a bad idea to have students work two jobs to pay the community-college tuition when they’re struggling to maintain a 2.00 GPA, but you can certainly expect them to find their own funding if they want more than four years of State U.

Another issue, frankly, is personal discipline. I have to admit that I’m hugely envious of our daughter’s college life. Even with the extra demands of NROTC (and keeping up with the academics at a top engineering school among freakishly brilliant classmates), she has more social life & liberty in one semester than I accumulated during four years at mine. However I’m kidding myself. At her age I had few organizational skills and even less personal discipline, and the U.S. Naval Academy was exactly the “supportive environment” that I needed. If I’d gone to her university I never would’ve finished freshman year.

After observing the college-funding debate for a few years, I think it’s reasonable for a parent to subsidize two years at community college plus two years at State U. For students who want more, I think there’s plenty of financial assistance from scholarships, grants, loans, & jobs. That gives a student enough study time to keep up with the academics while forcing them to put their own skin in the game.

Some parents will feel that their kids “deserve” more. I guess those parents should be willing to work longer to pay for it. Personally, I would not feel guilty about achieving early retirement while funding some of a kid’s public education. I know that my retirement time spent with our daughter has been far more valuable to both of us than the money I’d earn by continuing to work. I’d rather teach her how to live than to buy her a degree.

 

A 529 account may not be worth the tax savings

Now that a parent can decide how much they really want to save for college, perhaps a 529 account is no longer so significant. Its main advantage is tax-free investment gains (and possibly a state tax deduction), yet many 529s still have high expenses and poor asset classes. It’s also “risky” to lock up $250K in a 529 instead of having it available for other spending, but perhaps not so risky when the amount is “only” $20K.

We didn’t use a 529 for our daughter. She was born in late 1992, before 529s were created, and back then the best option was education savings bonds. We put aside $400/month in EE bonds until their fixed rates ended in 1996.

529s were available by then, but even after taxes their expenses were higher than Vanguard (and even Fidelity). The EE bonds offered enough tax-free savings for at least a couple of years at UH, so it seemed more prudent to counter education inflation by taking bigger risks with equities. We kept investing $400/month until 2010, but we did it in our own taxable accounts and not in a 529. At first it went into a “global value” equity mutual fund. During the 2001-02 bear market we bought shares of Berkshire Hathaway. In 2005 we tweaked the asset allocation with some education I bonds. Holding individual stocks & I bonds is cheaper than mutual fund expenses, we didn’t have to pay taxes on the gains until we sold, and the money wasn’t locked up in a 529.

By early 2008, Berkshire Hathaway had hit an all-time high and the stock markets were heading for record lows. We cashed out the equities and parked the funds in a CD ladder. We incurred large capital-gains taxes on these college funds, but “luckily” we managed the losses in the rest of our portfolio to offset that expense.  The bonds & CDs got us through the bear market, and our daughter started college in August 2010.

While I was juggling the college finances, our daughter had other college plans. At first it was a USNA appointment, but later she elected to go NROTC. The Navy is paying her nearly $18K (!) per semester (!!) in tuition/fees. (I must modestly admit that her military performance and her GPA are great bargains for the Navy’s money.)  NROTC is even kicking in another $5K-$10K for summer school while we parents are paying “only” $6300/semester in room/board and another ~$1000 during summer school. If you’re doing the math you can see that the four-year degree will cost over $200K… but our daughter’s paying for most of it with her five-year service obligation. She seems pretty motivated, too.

 

Military families already have tax savings

Brandi, your concern is justified– as long as I was in the military, I wouldn’t put much in a 529 account. I don’t have a spreadsheet to back this up, but I suspect that the vast majority of military families don’t save enough in taxes to justify a 529 account. Servicemembers already reduce their tax bills with tax-free military housing allowances, we can defer even more taxes through the Thrift Savings Plan, and few states tax a military pension. Additional tax credits are available to offset college expenses. In some 529 plans, the higher expense ratios will cost more than a taxable Vanguard or Fidelity Spartan index fund. Especially for one-child families, I don’t think a 529′s benefits are worth the liquidity risk or the expenses.

If I was starting over again today, I’d still buy I bonds when the rates were attractive. They’d form the inflation-protected “safe” portion of the college savings for about two years at State U. I’d put the rest of the college savings in a low-cost tax-efficient equity index fund from Vanguard or Fidelity or Schwab (and pay the annual taxes). I’d also sign my kid(s) up for one month of GI Bill benefits, although those benefits are probably best used on parental education.  (Fellow blogger Kate Kashman (Paycheck Chronicles) recommends using the GI Bill for your own education, which will boost your income by far more than it’ll ever transfer to your kids.)  If I had more than one kid and was accumulating a large college fund, then I’d put about half of the equity allocation in a 529 account. At least one of the kids could use the money without me worrying about having to retitle it for my grandkids.

Although our daughter’s college is horrifically expensive, you’ll notice that the Navy is paying nearly three-quarters of the bill. We parents will have money left over, and I’m glad it wasn’t locked up in a 529 account. We could buy a really nice car or even a boat, but I already have enough longboards to entertain me for the rest of my life. Instead it seems like a better idea to move a little “leftover” money to our daughter now instead of an inheritance (much) later. Our profit-sharing graduation gift is enough money to help her max out her TSP and her IRA for the first year or two of her service. The tax-deferred (and tax-free) compounding of that money will be far more significant than any 529 for her kids, and will certainly be more useful than an inheritance. She’s earned it.

Our parental gifting would also fund a mighty nice car or even a boat for her, too, so this profit-sharing generosity might not be justified with every college graduate. Gotta know your young adult, and I suspect that ours will continue to save a large percentage of her paychecks for early retirement. She’s seen us living the dream for over half of her life, and she wants to get her some of that financial independence for herself. We both hope she finds an avocation that she’ll love, but it’s a lot easier to search for it when you’re financially independent!

 

Related articles:
How much should you save for college?
Early retirement and the kid’s college fund

Does this post help? Sign up for more free military retirement tips by e-mail, Facebook, or Twitter!

Filed Under: Finances · Tagged With: , , , , , ,

Roth TSP: 7 May, but later for military

April 16, 2012 by · 3 Comments

 

 

You’re probably as tired as I am of these blow-by-blow breathless updates on the Roth TSP.  At least the military’s Defense Finance and Accounting Service is doing a better job of coordinating their announcements with the federal Thrift Savings Plan.

The board of governors of the TSP has announced that the Roth version of the TSP will go live on 7 May. They mentioned that some services have not yet finished programming their pay systems to handle Roth TSP deductions, so those services will implement the Roth TSP as soon as they’re ready.

Unfortunately those laggard military services are… all of them. The Defense Finance and Accounting Service announced last week that their computer systems still need more testing before they’re ready for the Roth TSP. DFAS expects to have the Roth TSP ready for DoD civilians and the Marine Corps by this summer.  According to the DFAS website, the Army, Navy and Air Force will join in by October 2012.  However one commenter has heard an ugly rumor that the Army Roth TSP won’t even be ready until 2014.

If you’ve heard any official announcements (or even good rumors!) from your service, whether they’re ready or not, then please post a link in the comments below. I’ll track down the scuttlebutt.

Here’s a quick review of the Roth TSP. It has the same $17,000/year contribution limit as the regular Thrift Savings Plan, with the same additional contribution limits for those over 50 years of age or on duty in combat zones (but see the next paragraph). Contributions can be split in any ratio between the Roth TSP and the TSP as long as those total limits aren’t exceeded. Younger servicemembers (and junior servicemembers) will generally enjoy a bigger long-term tax benefit by contributing to the Roth TSP now. You’ll pay taxes on the contributions now, but you’ll be able to withdraw them tax-free later in life. (Even if you’re financially independent, your tax rates may be higher.) There are some elements of risk to this strategy, however, so you may want to split your contributions to both the Roth TSP and the “classic” TSP. More details of that discussion are at this post on whether the Roth TSP is right for you.

A number of restrictions apply to contributions from combat zones and for those over age 50. Review those restrictions at The Military Wallet’s excellent summary on TSP contributions and then check the latest rules with your service’s pay office.

If there’s any good news about this update, it’s that the smaller branches of the federal government are going to be the guinea pigs for testing the computer systems that will handle contributions to the Roth TSP. Hopefully DoD will learn from their free experience and will iron out the glitches by the time they take their systems live.

I’ll continue to Tweet about the Roth TSP as more information is available, and my tweets also go out through “The Military Guide” Facebook page. Sign up to follow @TheMilitaryGuid (no “e” in that Twitter handle) or subscribe to the Facebook page.

 

Related articles:
Is the Roth Thrift Savings Plan right for you?
TSP tips and trivia
TSP withdrawal options
Where to put your savings while you’re in the military

Does this post help? Sign up for more free military retirement tips by e-mail, Facebook, or Twitter!

Filed Under: Finances · Tagged With: , , , , , ,

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.

——————————————————————————————-

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/

Does this post help? Sign up for more free military retirement tips by e-mail, Facebook, or Twitter!

Filed Under: Finances · Tagged With: , , , , , , ,

TSP tips and trivia

February 8, 2012 by · 10 Comments

I read a number of personal-finance discussion boards, and one of the largest is Bogleheads.org.  Their best feature is the user’s wiki, which has grown way beyond a basic FAQ page to become one of the Internet’s top unbiased online guides to investing and retirement.

Just over a year ago a poster started a thread on military investing topics which has been expanded and formatted as a new wiki page on military finances.  And, yes, they even linked to “The Military Guide“.

Take a look at their wiki page on the Thrift Savings Plan. I knew that the TSP was one of the world’s biggest collections of index funds, but then I came across the Federal Retirement Thrift Investment Board website. That eventually led back to the biographies of the FRTIB directors at the TSP website, where the executive director’s bio says: “The TSP services 4.5 million current and former Federal employees and Uniformed Service members with over $289 billion in assets, making it the largest defined contribution plan in the world.” So now you know that servicemembers invest in the world’s largest 401(k)– and with the world’s lowest expenses, too.

One of the most comprehensive websites on using the TSP is Ryan Guina’s “Military Wallet” Thrift Savings Plan tab.  He explains both the benefits of investing in the TSP  and the drawbacks.  One of the more popular posts explains how to handle TSP tax-exempt contributions and withdrawals  , and he’s also following the Roth 401(k) plans for the TSP  (still scheduled to start during 2Q12).

Most TSP investors (especially busy servicemembers) are happy to contribute their allotments to the funds and to occasionally tweak their asset allocation. That’s probably the best way to handle our TSP accounts. However many others would like to see more details on the TSP’s funds and compare them to products from major fund companies like Vanguard or USAA. The TSP funds still have the lowest expenses, but the TSP website doesn’t answer questions like: “How does the ‘C’ fund’s performance compare to the competition?” “How will the ‘I’ fund be affected by a foreign country’s debt default?”

One of the most frequent questions is: “What are the ticker symbols for the TSP funds so that I can track their performance on my investment software?”

The TSP managers don’t answer those questions because they don’t have a marketing staff.  (They have “only” 80 people to manage the world’s largest funds and they’re considered to be one of the smaller federal agencies.)  They don’t even want to pay for the expense of maintaining a TSP ticker system. To fill the information void, a host of unofficial TSP websites offer the data that you won’t get from the TSP itself.

One of these is TSP Center.  It includes archives of TSP data and share prices as well as a wealth of analysis tools for choosing an asset allocation. It also has a blog, a discussion board, and a “FantasyTSP” analyzer. You can download your own data or use their tools. You can tinker with different asset allocations and see how your TSP assets interact with your IRA and taxable accounts. You can follow their updates on Facebook.  If you have a question that the TSP website doesn’t answer, one of TSPCenter’s 4000 members can help you figure it out.

TSP Talk is another site full of tools and archives.  Its “TSP AutoTracker” gives you an easy way to monitor your TSP fund’s performance with daily quotes and analysis. Its “Tools and Utilities” section offers member blogs, data charts, and e-mail alerts for TSP news releases. The site includes a forum with thousands of members who’ve probably answered every TSP question ever asked. Yep, they’re on Facebook and Twitter  too.

These sites and tools cater to active TSP investors. Use them to educate yourself and to choose a TSP asset allocation that works well with the rest of your investments. Don’t turn into a trader– TSP investors don’t have to be involved in their fund’s daily twists and turns, let alone switching from one fund to another every month. For the vast majority of servicemembers the most important aspects of the TSP are making regular contributions, choosing an asset allocation you’re comfortable with, and rebalancing every year or two. (I only update our TSP fund data a few times a year and have never switched from one fund to another.) However the blogs and discussion boards are fantastic education tools and reference sources. If you’ve been all over the TSP website looking for an answer, you might find it on one of the other websites.

I’ll be checking these sites over the next few months to see how the upcoming Roth TSP option is doing. If there’s a question about the rules or the implementation, these guys will be all over the answers.

Related articles:
Saving base pay and promotion raises
Retiring on multiple streams of income
Asset allocation considerations for a military pension (three parts!)
TSP withdrawal options
TSP annuity options
Exploring the Bogleheads’ Wiki – Asset Allocation (by Mel Lindauer of the Bogleheads)

Does this post help? Sign up for more free military retirement tips by e-mail, Facebook, or Twitter!

Filed Under: Finances · Tagged With: , , , ,

Military careers and retirement at risk

January 16, 2012 by · 9 Comments

 

 

It’s nearly that time of year again: DoD’s budget submission to Congress. Even worse, it’s an election year. The President typically sends the defense spending plan in the first week of February, and the debate begins. This drawdown is expected to cancel a number of new weapons programs and accelerate the demise of other hardware costs, and there’s significant pressure on personnel expenses. Secretary Panetta is expected to propose at least $450 billion in cuts over the next decade, but the real debate is whether the cuts will approach $1 trillion. Despite promises to “keep the faith”, servicemembers and retirees are rightly concerned that deeper cuts would be inflicted on the military’s pay and retirements.

The defense budget debate will play out on the political stage for months, but the services are already implementing their own cuts with the Army taking the lead. The Army also just announced that they’ll be removing two combat brigades from Europe, pointing out that two of the current four have spent much of the last decade deployed to Iraq and Afghanistan. The Air Force recently finished a four-month civil-service hiring freeze. Although hiring started again late last year, they’re also offering a second round of employee buyouts. The first round was estimated to drop over 9000 billets and the second is hoping to persuade over 4500 civil servants to leave. Air Force bases in Colorado are already cutting six percent of their civil-service staff and there’s significant worry that this round will lead to reductions in force. The Air Force is hoping that similar cuts will contribute to nearly $100B in payroll savings over the next decade.

The Air Force also finished the last fiscal year about 1200 servicemembers over authorized end strength, which seems to be an awkward start to their drawdown. (They’re going to hear a lot about that in the upcoming months.) They’ll probably make the reduction through voluntary separations and training pipeline attrition, and only one officer separation board is planned for the coming year. However they’re reducing high-year tenure limits on enlisted and tightening re-enlistments for certain specialties.

Unfortunately the Navy has taken an exceptionally aggressive stance with two “Enlisted Retention Boards” intended to cut nearly 3000 sailors from the force before October.  It was initially expected to be an early separation program for marginal performers, but the first round of notifications has led to an outcry of adverse publicity, a Facebook protest,  and even a White House review petition.  The full schedule of ERB proceedings is on the Navy’s BUPERS website.  The Chief of Naval Personnel, VADM Van Buskirk, has responded that crowded ratings should gain improved advancement opportunities, and the Navy will probably be able to avoid an ERB in 2013-2014. If it’s any consolation, I served briefly with Scotty in the early 1990s. He’s one of the good guys who’s already seen a vicious drawdown, and he understands the consequences for servicemembers & families.

Meanwhile there’s apprehension that any new 401(k)-style military pension system would cause both a drop in recruiting and a spike in separations.

The drop could come from a briefing released by the Defense Business Board last July.  The DBB’s proposal has been shelved by the new Secretary of Defense, but it could be recycled into a future retirement system. The feature would be a Thrift Savings Plan with matching DoD contributions similar to the current federal civil-service retirement system. Servicemembers would be free to leave the service after their obligation and start withdrawing their TSP benefits at around age 60. (The TSP already allows withdrawals anytime after age 59.5, but current TSP balances are much smaller because there’s no DoD matching contribution.) In other words, the TSP would be nearly identical to a civilian 401(k). Recruiters speculate that if the TSP replaces the current defined-benefits pension, then military retirement would no longer be as attractive. Potential recruits would see that the military retirement benefit is very similar to civilian programs but the military’s extra risk (without the extra reward) would discourage them from joining.

The “spike” concern is caused by the existing retirement system, where most qualify for retirement after 20 years. The vast majority of retirements also occur at 20 years, which implies that servicemembers were waiting for this “cliff vesting” and were not planning to stay any longer than the minimum requirement. If a new retirement system eliminated the 20-year vesting for a shorter one then servicemembers would leave even sooner.

The DBB proposal is dead, but its ideas have started a dialogue. It’s too early to know where this will end up, but it’s possible to make some predictions about the next decade.

What’s your best professional defense for a drawdown? A good offense. If you want to stay on active duty then maximize your performance, training, and qualifications. If you feel you have those areas covered then look for leadership positions, pursue a college degree, and keep finding ways to be an essential part of the team. You can’t control the selection process, but 30 years from now you want to look back on this era of your life and know that you gave it your best shot.

You can also take the offensive on the personal side: financial independence. This is a good time to get out of debt and keep saving, and not a good time to spend on material possessions. If you’re already planning to separate then make sure you attend the transition-assistance seminars and use all the program’s other resources. Be alert to announcements of separation incentives and be ready to respond within 24 hours. (There’ll be a stampede of applications.) Even if you’re planning to stay for 30, make sure you’re taking full advantage of the TSP and your Roth IRA. Save even more in taxable accounts so that you can sleep soundly at night knowing you have a “Plan B”.

A good friend recently left active duty and was hired in a civil-service position. He’s financially independent so he’s exploring his bridge career options while easing into a full retirement. However his local military base is already contemplating a RIF and held a meeting to explain the process to their civil servants. He noted “As I was setting there I was looking around you could see the fear in people’s eyes. Clearly this caught a lot by surprise. My guess is many have nothing and are just fat dumb and happy. If I get my walking papers I am fine with it.”

Financial independence: security and peace of mind.

This is a lot of gloomy drawdown news to absorb, but I’ll have a few rays of sunshine in the next post.

Related articles:
Military drawdown predictions
Changing military pensions
The military drawdown and benefits cuts
DoD panel proposes new retirement system
Will Congress change military pay?
Will Congress change military retirement?

Does this post help? Sign up for more free military retirement tips by e-mail, Facebook, or Twitter!

Filed Under: Military · Tagged With: , , ,

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

Does this post help? Sign up for more free military retirement tips via e-mail, Facebook, or Twitter!

Filed Under: Finances · Tagged With: , , , , , , , , , ,

Five Money Missteps

July 4, 2011 by · 6 Comments

State Farm Insurance recently published “Five Money Missteps to Avoid” in their monthly magazine. (Thanks for sending this, Jay!)

I’m a sucker for short lists that help you succeed one sound bite at a time. They’re a quick read, they’re easily compared to your own practices, and you don’t feel as if you’re slogging through a personal-finance marathon. The trick is applying them to your own situation, which frequently requires thinking about your own values and then analyzing the math.

Along with the article’s text, here’s a more in-depth discussion of these mistakes from a military family perspective:

1. Tapping into your retirement account early.
Good: Easy money! A quick solution for spending emergencies.

Bad: Higher income taxes plus possible penalties on the withdrawal. Once the money’s taken out of the retirement account, it’s no longer compounding for your retirement. 401(k)s can be tapped for a loan (you’re repaying yourself with interest), but if you lose your job then the loan is either immediately due or classified as an early withdrawal.

Other:
It’s possible to take a loan from the Thrift Savings Plan. If you must tap a retirement account then this one will probably have the lowest interest rate: whatever the G fund yields. That rate will be fixed for the life of the loan (1-15 years). You might even be able to arrange the loan without having to tell your chain of command, which is perhaps more attractive to some servicemembers than requesting advance pay. However the loan effectively busts your TSP account’s returns down to the rate of the G fund without any compounding benefit.

Don’t borrow from your retirement account. Consider the following options:

Again, although these withdrawals may not be penalized, they’ll be subject to income tax and won’t be compounding away in your retirement account.

2. Paying too much for your mortgage. (Both the payment amount and the interest rate.)
Good: “Gosh, we can live in a great house/location!”

Bad: You won’t spend much time in your great house/location because you’ll be working to earn the money to make the payments. If the housing market drops then you may even owe more money than your home is worth.

Really bad: Active-duty military may have to transfer on short notice, resulting in extra house/mortgage expenses that could lead to foreclosure or even bankruptcy.

Other:
A generation ago, mortgage lenders used to limit the payment to 28% of your after-tax income, while limiting total debt (house, car, student loans) to ~36%. This was conservatively based on decades of payment statistics because the lender was probably going to keep your loan on its books instead of selling it to Wall Street for “creative financial engineering”.

Even with today’s record-low interest rates, mortgage balances have been rising. In “The Two-Income Trap”, Elizabeth Warren claims that two-income couples have spent the last 30 years bidding up the prices of homes in good neighborhoods with good schools. This is especially problematic for active-duty military because they’ll transfer so frequently that they’ll rarely profit from real estate appreciation. Equity gains (if any) will be spent on the transaction costs and unreimbursed moving expenses.

The only time to keep a mortgage with a higher interest rate is when you’re aggressively paying it off early. Do the math: the total difference of the higher monthly payments should be less than the refinancing costs. In most cases this difference will be just a few years of higher payments.

While you’re on active duty it’s almost always safer to rent (or to live on base) than to own. After you leave active duty there will be plenty of time to find a good home and make a fortune in real estate.

3. Confusing sticker price with affordability. State Farm says “Being able to make a monthly payment doesn’t necessarily mean you can afford a purchase. If you want to buy a car but can’t also manage the insurance, gas and maintenance expenses, you can’t truly afford the purchase.”
Good: “Wow, look how much money I can borrow!!”

Bad: Eventually you’ll have to pay it back.

Other:
The root of this misstep is the retailer’s dream: shopping based on how much you can (probably) pay, not on how much value you’ll receive. Every car sales rep knows that buyers are much more susceptible to maximizing their monthly loan payment than they are to assessing how much that vehicle (and the loan) will cost them.

The best approaches?

  • Save up the cash to buy the car.
  • Try to choose housing and work locations that minimize the commute.
  • Use alternate transport (public transportation, carpools, bicycling) as much as possible.
  • Buy a used vehicle in a model with a high reliability record.

4. Saving for your child’s college education instead of your retirement. State Farm says: “Many families opt to fund college accounts before contributing to their long-term savings. But experts agree that while there are affordable college loans, there aren’t comparable loans to cover basic retirement expenses– so pay yourself first.”
Good: Nothing about this is good for you. It might not even be good for your college student.

Bad: You’re sacrificing your retirement future in the hope that your kids will get a good return on your investment. This is problematic.

Other: Find more food for thought on this controversial subject in these posts:
Early retirement and the kid’s college fund
How much should you save for college?

5. Not protecting your income. State Farm says: “If you suffer a disability and can’t work then every person who relies on your income will be negatively impacted. Disability insurance can protect your family against the loss of a paycheck by making up a sizable chunk of that lost income.”
Good: When you’re on active duty, your disability benefits are far more affordable than the civilian equivalent.

Bad: Most of the military’s occupational hazards tend to be deadlier than civilian careers.

Other:
When you’re leaving active duty, pay close attention to your medical & dental records to make sure that any potential disability issues are evaluated and assessed. This is tedious and time-consuming, so start at least six months early and don’t be dissuaded by the bureaucracy. As hard as it may be, it’s far easier to complete this process on active duty than after you’ve left the service.

If you pursue a bridge career after the military then buy disability insurance. It’s just as essential as life, home, vehicle, and liability insurance.

Related articles:
USAA: seven money rules to break
Medical and dental exams

Does this post help? Sign up for more free military retirement tips via e-mail, Facebook, or Twitter!

Filed Under: Finances, Military · Tagged With: , , , , , , , , , ,
«Older Posts
%d bloggers like this: