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