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Too much TSP?

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A Boston University professor and two researchers at the Federal Reserve Bank of Cleveland offered a heaping plate full of retirement-savings heresy in a recent paper. "Participating fully in 401(k) and similar tax-deferred savings vehicles appears to raise, rather than lower, the lifetime tax payments of most workers, namely those with low and moderate incomes," professor Laurence Kotlikoff and Fed researchers Jagadeesh Gokhale and Todd Neumann wrote in a May 2001 paper, "Does Participating in a 401(k) Raise Your Lifetime Taxes?" Contrary to the conventional wisdom that people should contribute as much as they can to the Thrift Savings Plan and similar tax-deferred retirement savings programs, the authors say that because of the way the government taxes Social Security benefits, many people should consider limiting the amount of money they stow in tax-deferred programs. "The taxation of Social Security benefits appears to be the most important factor in transforming full 401(k) participation from a good to a bad deal for most workers who earn moderate to high rates of return on their savings," the authors wrote. The researchers used a financial planning model to come up with their conclusion. Looking at a series of hypothetical couples, the researchers found that a couple with $50,000 per year in income with a 6 percent return on investments wound up paying 1.1 percent higher taxes and saw a 0.4 percent reduction in spending over their lifetimes by fully participating in a 401(k) plan. 401(k) participation pushed middle- and low-income households into higher tax brackets in retirement and made more of the couples' Social Security benefits subject to taxation. The authors added a caveat: employer matching contributions, such as the federal government's matching of TSP contributions for employees in the Federal Employees Retirement System, more than make up for the increase in the lifetime taxes that they computed. So employees may want to continue making contributions to get their employers' match. But then they may want to invest additional money in a Roth IRA rather than in a 401(k)-like program such as the TSP. "The federal government has spent over a quarter of a century encouraging workers of all stripes to save in tax-deferred retirement accounts," the authors wrote. "The government has encouraged workers to believe they would be saving taxes on a lifetime, rather than simply a short-term, basis… But for those at the lower end [of income distribution], 401(k) participation may represent more of a tax trap than a tax shelter." But don't start reducing your TSP contributions just yet, said David Wray, president of the Profit Sharing/401k Council of America, based in Chicago. Wray said the researchers' methods were flawed. "They used an extreme example," he said, arguing that the assumptions used in the analysis supported a pre-determined conclusion. "In many, many ways, it was flawed," he said. The analysis, for example, failed to take into account the lower administrative fees in deferred-contribution plans such as the TSP. Wray conceded that Social Security taxation rules penalize people who save money for retirement, but not to the extent that people should stop saving. "People should feel comfortable taking maximum advantage of 401(k) plans and other deferred compensation plans," Wray said. The researchers' report is available on Kotlikoff's Web site at http://econ.bu.edu/kotlikoff. It at least makes people aware that high TSP earnings may increase the tax on their Social Security income. Retirement Corrections Update So far, about 5,400 current and former federal employees (and their survivors) have asked the Office of Personnel Management to review their retirement classifications to make sure they're in the correct retirement systems. OPM will correct retirement errors for people in the wrong system, thanks to the Federal Erroneous Retirement Coverage Corrections Act, which President Clinton signed last year. OPM has hired consulting firm KPMG to figure out who is eligible for help and who isn't. OPM expects KPMG to mail decisions out beginning in late August, starting with retirees and survivors. The decisions will be accompanied with information on what to do next. People will be able to get help over the telephone after they receive decisions by mail. If people aren't happy with the decisions that KPMG makes, they can appeal to OPM. In May, OPM predicted that KPMG would start issuing decisions and conduct telephone counseling in June. Why is the start date in August now? "There's a lot of work that needs to be done to get ready for this task," an OPM spokesman explained. But he added that even the August prediction is tentative and subject to change. The affected employees are accustomed to waiting. Most were placed in the wrong retirement system by their agencies during the switch from the Civil Service Retirement System to the Federal Employees Retirement System in the 1980s. The House Government Reform Subcommittee on the Civil Service first held a hearing on the retirement errors in July 1997, four years ago this month.
 

Brian Friel is founder of One Nation Analytics, an independent research, analytics and consulting firm for the federal market.

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