A reader writes:
“The goal: We are trying to reduce my taxable income while increasing my Roth contributions. I am in a combat zone through August, so my pay has been tax free, but will soon change. We have converted my spouse’s traditional IRA to a Roth IRA and expect a tax bill.
The question: Will my Jan-Aug tax-free pay’s contributions to traditional TSP reduce my Sep-Dec taxable income? In other words, will the whole year’s-worth of TSP contributions reduce my four months of taxable income?
If not, I should not contribute to traditional TSP until September, then do everything I can. But if Jan-Aug’s TSP contributions do reduce Sep-Dec’s taxable income, I should skip traditional TSP and instead put everything into my Roth IRA. This is what I am hoping for. Minimizing any additional taxable income is our goal. Right? Thanks.”
Thank you both for your service and your sacrifice. The reason I’m able to answer financial independence questions like this is because you guys are dealing with combat duty.
Congratulations on thinking ahead with the Roth IRA conversion. In general, it’s a good idea to pay the conversion taxes from your other assets (not from your IRA assets). Your income tax rates will probably be higher after age 70 (especially if you’re earning a military pension) so it’s better to do the conversion in a year when the tax-free combat pay means that your tax bill is so low. Years from now you won’t have to worry about RMDs from conventional IRAs or paying more taxes on your Social Security. Paying the conversion taxes from other assets today leaves all of the Roth IRA to continue to compound tomorrow. In other words, you’re already winning the tax game in the third quarter. Now it’s just a question of how much you get to run up the score.
I think your September-December taxable pay is NOT reduced by the contributions that you’ve made so far. I think that taxable income is only reduced by conventional TSP contributions in the month during which the taxable pay is earned (when the deduction is made by DFAS from your pay and sent to the TSP). The good news is that your Jan-Aug pay was not taxed at all, so the taxable income block on your Leave and Earnings Statement is still probably “zero”. Once you leave the combat zone, your base pay (and other specialty/bonus pays) will revert to “taxable” and you’ll start building up a taxable LES balance for your W-2.
When your tax-free pay goes to the conventional TSP, it’s already “not taxed” so it doesn’t reduce your taxable income (or your tax bill). Your taxable income block on your LES will not go negative. No worries– the conventional TSP contributions that you’ve made so far in 2013 are still serving a good purpose. The TSP tracks your combination of conventional tax-deferred & tax-free contributions, and decades from now when you start TSP withdrawals then some of the withdrawal will not be taxable because a portion of it is this year’s tax-free contributions.
However, you can still reduce your September-December taxable income by maximizing your contributions to your conventional TSP account. Better still, because you’ve been in a combat zone you have higher limits on your total TSP contributions. You can put up to $17,500 of your tax-exempt contributions into the Roth TSP and another $33,500K of tax-deferred (or tax-free) contributions into the conventional TSP for a combined total limit of $51K.
I’m not a CPA or a CFP, so you should check that with a financial advisor like Jason Hull at Hull Financial Planning. (Jason will answer your question for free if you make fun of the U.S. Naval Academy!) You could also check with USAA’s Scott Halliwell & J.J. Montanaro, or in person with a CFP at your base’s family support center.
Regardless of where you serve each year or what you’re getting paid for it, I think you should try to maximize your TSP contributions before contributing to your IRAs. One reason is that you’re only able to contribute to the TSP while you’re in the military (or federal civil service). The next reason is that the TSP funds have the world’s lowest expense ratios. (Even lower than Vanguard.) The final reason is the TSP’s “G” fund, which is a guaranteed return that can act like a high-quality bond in your overall asset allocation plan. You may not want to use it, but it’s a great option.
I recommend you take a hard look at your expenses and try to contribute enough of your Sep-Dec (taxable) pay to max out the conventional TSP ($33.5K-$51K, whatever’s not already contributed in the Roth TSP). That will cut your 2013 taxable military income to an all-time low and possibly reduce the tax bracket on the income from the Roth IRA conversion. Once you achieve that TSP contribution goal, then max out your Roth IRAs.
By the way, the Defense Finance & Accounting Service will let you contribute over 90% of your pay to the TSP. When my spouse was a Reservist earning a few hundred bucks for a drill weekend, we used to set her TSP contribution at 92%. (The Defense Finance and Accounting Service reserves the other 8% for FICA withholding.) The TSP will track your contributions during the year, and when you slam into a limit ($17,500 in the Roth TSP or the $51K total TSP contributions) then it’ll automatically stop the deductions and return any excess contributions to you through DFAS.
I agree that there are a few special situations where you would want to avoid “locking up” your money in the TSP. One of those situations is if you’re saving up to buy a house. You can withdraw your Roth IRA contributions anytime and another $10K for a first-time home purchase. Another situation is if you’re leaving the military in a year or two, and stashing as much money in your personal accounts as possible for transition living expenses.
Combat zone contributions to the Thrift Savings Plan
Is the Roth Thrift Savings Plan right for you?
Three reasons to keep your retirement savings in the Thrift Savings Plan
When do you stop contributing to tax-deferred accounts?
Ask your Dad if you should contribute to the Roth TSP.
TSP withdrawal options
Where to put your savings while you’re in the military
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