Combat Zone Contributions to the Thrift Savings Plan



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


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WHAT I DO: I help you reach financial independence. For free. I retired in 2002 after 20 years in the Navy's submarine force. I wrote "The Military Guide to Financial Independence and Retirement" to share the stories of over 50 other financially independent servicemembers, veterans, and families. All of my writing revenue is donated to military-friendly charities.

  1. Here is the follow-up on what I’ve decided to do: After some more research, I learned that I can transfer the balance of my TSP into IRAs, with the regular contributions going to a Traditional IRA and the Roth and tax-exempt contributions going to a Roth IRA (I confirmed this on the phone with USAA). So the tax-exempt portion can be rolled over into a Roth instead of just being tax-deferred and eventually owing taxes on the earnings. This is a huge tax benefit that I didn’t consider before, and so I am ramping up my tax exempt contributions whenever able. I’ll hate to miss out on those low expense ratios, but tax-free earnings will save me more money in the long run. I plan on separating in 18 months, and at that time this is what I expect my TSP to look like:

    Total TSP Balance: 150,000
    – Traditional: $95,000
    — Tax exempt: $37,500
    – Roth: $55,000

    If I were to leave it in the TSP for 30 years and earn 6%, the tax-exempt portion would grow to about $215,000 and I’d owe about $45,000 in taxes (assuming I’m in the 25% bracket). The higher fees at Vanguard would cost me about $30,000 more over 30 years, but moving everything into IRAs also gives me the opportunity to convert the Traditional into a Roth, which I plan to do bit by bit over the years. The one drawback I see is that I will be limiting the amount of taxable funds for early retirement, but I think I’ll have so much invested in my Roth that it won’t pain me too much to withdraw some contributions penalty-free.

    • Sounds like a great plan, Brandi, congratulations!

      I’m not sure that a TSP rollover from a conventional TSP account will allow you to send the taxable contributions to one rollover (conventional Roth) account and the tax-exempt contributions to another rollover (Roth IRA) account. Instead they’ll just show which percentage or what amount of the rollover comes from tax-exempt contributions. However you could try to confirm this with the TSP– maybe they’ve updated their system to handle this issue.

      Vanguard is not going to be familiar with tax-exempt contributions rolled over from a conventional TSP. (I trust USAA’s CFPs like Scott Halliwell and J.J. Montanaro to guide you through the process, but Vanguard does not handle exceptions well.) If your tax-exempt contributions all went to a Roth TSP and are rolled over to a Roth IRA then Vanguard will never know there’s a difference and it’s not a problem.

      However if any of your tax-exempt contributions went to a conventional TSP account, then Vanguard may not recognize that tax-exempt classification. Vanguard may insist that all of the rollover is made from before-tax income (and they’ll try to classify it as all taxable when rolled into a Roth IRA). Of course you might be able to track this on your own through IRS Form 8606 and not worry about Vanguard’s tracking. However it may be better to leave those contributions in your TSP so that your earnings can be withdrawn tax-free.

      I might see Scott & J.J. at next week’s FinCon. I’ll add this to my list of obscure tax questions for them or send them an e-mail afterward…

  2. Nords,
    You make a compelling argument between TSP and taxable account due to tax implications. As I saved for retirement, I didn’t really have a clearly articulated retirement financial plan. I knew early in my military career that I should continue to live below my means and save/invest as much as I can. When I married my wife (who is just as dedicated than me, if nor more so, to saving and living frugally) our savings/investment efforts just went on overdrive. Before I knew it, the savings/investments kept growing…weathering the ups and downs of the market.

    It wasn’t until recently that I focused much needed attention on a tax-efficient financial plan, thanks to the many hours trolling the Bogleheads forum and your blog, among other resources. As you indicated, we do not have a crystal ball and would be hard pressed to predict what the tax rates would be 10, 20, 30 years from now. With a generous military pension, one could find themselves in marginal 25% or 28% tax brackets on their pension alone. Will the capital gains rates stay as they are or will they increase in the future? Who knows?

    Hedging your bets by splitting contributions between TSP and taxable accounts (once you’ve maxed your Roth TSP and Roth IRAs) makes sense.

    • Thanks, Mel!

      I think every servicemember should max out their TSP contributions early in their career, just because the expenses are so low and the opportunity stops when they leave the service. But as the end of service approaches, then early retirees (or veterans in transition to a bridge career) need to have easy access to funds from taxable accounts.

      Dual-military couples with at least one active-duty pension will definitely be in a higher tax bracket when RMDs start. In that case it’s better to convert conventional IRAs and the TSP to Roth IRAs before age 60 (when a Reserve pension kicks in) or age 70 (when RMDs are at hand). I’ve been converting a little every year for the last decade but we only have eight more years before my spouse’s Reserve pension kicks in…

    Comment? Question? What's on your mind?