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.
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