By Mike Miles
February 20th, 2012 | Uncategorized
Judging by the enthusiasm I’ve seen, some Thrift Savings Plan participants clearly believe that the new Roth option will be the solution to any and all retirement income problems. The option is set for launch as early as April, with whatever benefits it might produce.
TSP has promised additional details as the availability date draws closer. Right now, you can get a peek under the hood on the TSP website.
The Roth TSP option will allow you make deferrals of after-tax dollars from your paycheck into the plan. If you meet the requirements, which include being at least age 59½ and having held the Roth for at least five years, you may withdraw both your contributions and any earnings, free from federal income tax. Traditional TSP contributions are made with pre-tax payroll deferrals, which are taxed, along with any earnings, when they are later withdrawn.
So the traditional TSP offers tax deferral — avoid tax now and pay tax later, while the Roth TSP offers tax acceleration — pay taxes now so you won’t have to pay later.
Once Roth is available, you’ll be able to split your payroll deferral into the TSP between the traditional and Roth options. The usual TSP contribution limits — currently $17,000 per year for those under 50 and $22,500 per year for those age 50 and over — will apply to your total contributions each year.
Any agency contributions will be made to the traditional TSP part of your account. You will not be permitted to convert your traditional TSP balance into the Roth option. You may transfer certain Roth employer-sponsored retirement plan balances from the private sector into the TSP, but you may not transfer in Roth IRA money. Your TSP deferrals will not affect your ability to contribute to a Roth IRA each year.
I find it disappointing that it appears that you will not be able to manage, or withdraw, money selectively between the two options. Your contribution allocation and any interfund transfers you direct will apply to both options. Any withdrawals will be taken, pro rata, from both options. You may, however, split a rollover distribution between traditional and Roth IRA accounts.
I’m on record as being unconvinced about the potential benefits of “tax now” versus “tax later” retirement plan contributions. There seems to be a widely held misperception that, somehow, there is an inherent advantage to being taxed now on a small amount, so that you (probably) won’t be taxed later on a larger one. Not so. If the tax rates are the same at both ends, the results are identical.
Any advantage that might accrue must come from differences in the tax rates applying to contributions and distributions. Lower tax rates at the time of contribution will create an advantage for the Roth investor. Lower tax rates at the time of distribution will benefit the traditional TSP contributor. In most cases, it is impossible to know whether contributing to a Roth account will work for you or against you.
For those who can afford to contribute the maximum in after-tax money, the Roth option offers a nice opportunity to put more money than before into the best retirement savings and investment vehicle around.
For most others, the main reason for participating in the TSP Roth option is to hedge the traditional TSP’s inherent bet on lower retirement tax rates. It’s not a bad idea, but is it worth the increased complexity and uncertainty you’ll face in deciding whether to use it, or in actually contributing to it? Hopefully, Roth will not include higher expense ratios and correspondingly lower investment returns, but only time will tell.
In my experience, where you save the money is not nearly as important as that you save it — somewhere. That reality holds as long as we are talking about after-tax equivalent amounts.
I have analyzed scenarios for a variety of hypothetical and real federal employees and found a range of outcomes, depending on the circumstances. In some cases, replacing traditional TSP contributions with after-tax-equivalent Roth contributions helped; in others, it hurt. In all of those analyses, however, the range of outcomes is relatively narrow.
Based on these results, the decision of whether to participate in the TSP’s Roth option is not likely to change your standard of living in retirement by more than a few percentage points one way or the other. So don’t spend too much time and effort worrying about it. There are bigger factors in the retirement equation that deserve your attention.