March 2, 2012
Did you know that last week was America Saves Week? The idea behind the event was to urge Americans to assess their savings progress and take action to start saving or to save more effectively.
I thought I would pick up the savings theme this week by helping you evaluate the latest addition to the Thrift Savings Plan, which will be available later this spring: the Roth TSP option. You’ve probably heard about this, since the annual TSP participant statement that came in the mail recently included a pamphlet with information about it. The Roth option also was the focus of the most recent TSP quarterly newsletter. The TSP Board put out a fact sheet in 2011 about the option. And if that isn’t enough information, you also can watch a video about it.
These publications and presentations all contain the following advice: “You may want to consult a qualified tax or financial adviser to help you decide if Roth is for you.” I decided to heed that advice and consult with two experts: my colleague, Bob Leins, a certified public accountant and tax adviser with Gold, Leins and Adoff in Rockville, Md.; and Joe Sullender, a financial adviser with Wells Fargo Advisors LLC in McLean, Va. (Wells Fargo Advisors is not a tax or legal adviser.) I put some questions to them and got some interesting answers.
The conventional wisdom is if you think you’ll be paying higher taxes in the future, then you may want to pay the taxes now on the money you’re saving for retirement and use the Roth option. Then you will be able to withdraw that money tax-free down the road. Is this correct?
Bob: Maybe yes, but probably not if the employee is very close to retirement and there would only be a year or two of Roth TSP contributions -- and the employee’s income was relatively high.
Joe: This is a big one. I totally agree that all the signs are there that tax rates will be higher in the future. I also agree that if the time frame is shorter between contribution and withdrawal, the traditional, tax-deferred TSP makes more sense. It's funny -- we have a Roth 401(k) here at my job and I don't contribute to it, though. (I do the traditional 401[k]). My theory here is that since I am in the private sector and in a higher tax bracket now -- and likely to be in a "nothing" bracket in retirement (I will not have a traditional pension or federal retirement benefit) -- I should do the traditional approach for the tax deduction.
Bob: To be frank, I have been of the same philosophy Joe just mentioned until recently. Looking at the tax rates proposed in the president’s 2013 budget, I might convert some IRA/retirement plan funds to a Roth. The problem with the budget proposals, whether enacted in whole or in part, is they will impact very high tax brackets.
Like Joe, I have no retirement plan other than savings and will probably work a long time. Project that out over a number of years and my savings are going to take a tax pounding. As a result, the Roth is starting to look better for a piece of my savings.
A lot of younger employees don’t understand that their traditional TSP savings reduce the amount of tax withheld from their salary. If they switch to the Roth, they will not have the same net income for the dollar amounts being saved. This may cause some lower-salaried employees to save less since they will need the same net income to pay their living expenses and reduce their debt for student loans, car payments, rent, mortgage, etc.
Bob: Employees should consider the Roth TSP option even though they would be saving with after-tax dollars. Unfortunately, some people dismiss the Roth opportunities by making the classic wrong assumption that only tax-deductible investments are good. So everyone should conduct an analysis. There are calculators to do this. They’re not TSP-specific, but that doesn’t make too much difference because the rules for the Roth 401(k) plan contributions are the same as the TSP contribution limits. The limits for 2012 are $17,000 for employee contributions to both traditional and Roth TSP accounts, plus $5,500 in “catch-up” contributions for employees who are age 50 or older this year.
Joe: The Roth TSP likely wins for feds. I think the issue Bob could address is: Does the increase in modified adjusted gross income from not making regular TSP contributions put someone in a rougher spot on their 1040 tax form? Do they now hit the alternative minimum tax, or lose other deductions and credits?
Bob: There will be an increase in modified adjusted gross income from not making regular tax-deferred TSP contributions. This is a result of the Roth TSP not reducing your MAGI for income tax while the traditional TSP does reduce MAGI. The higher MAGI generally will increase taxable income. Direct results of increased MAGI could include: an increase in your income tax caused by the dreaded AMT, lower itemized deductions, becoming ineligible for certain tax benefits, and higher Medicare premiums if you (or, if you’re married, your spouse) are enrolled in Medicare Part B.
Some employees will retire and start their own businesses or a second career and could actually have a higher income than they had while working for the government due to receiving a retirement that replaces 30 percent to 80 percent of their salary and having a second source of income. Is there a difference between wondering whether there will be higher tax rates in the future and thinking it’s likely you could simply be in a higher tax bracket?
Joe: I agree with the logic, but I don't think I would make big bets today based on my retirement tax bracket or where rates go.
How do you evaluate whether it is worth giving up the tax break now so you won’t have to pay taxes later?
Joe: To me this is the primary issue. The regular TSP helps you now; the Roth helps you later. It can be argued based on circumstances how far out the "break even" is from deposit to withdrawal, where the Roth TSP starts to shine. My rule of thumb has always been 10 years, but this is very arbitrary. I also should add that the absence of forced withdrawals at age 70 1/2 plays a role. If you make TSP contributions, you may have no intention of withdrawing the money but are forced to start taking it out in pieces at 70 1/2. If you live long enough, you can withdraw a great deal of money and pay a lot of taxes. The Roth TSP will allow you to transfer your savings to a Roth IRA, where you wouldn't be required to do this, making it a no-brainer for people who don't intend to use the money in retirement, except in case of emergency.
If you would like to host a mini-Roth TSP course at your agency, feel free to contact the National Institute of Transition Planning.
March 2, 2012