A pension can make retirement more secure, but It can also change the tax picture

Terry Gerton We’re tackling some interesting topics on a monthly basis. And this month we’re going to talk about Roth options in your TSP. They became an option back in 2012. What’s kind of changed since then?

Thiago Glieger The Roth TSP is a different way of taxing the money. And there’s been a lot of recent excitement about the Roth component of the TSP because the TSP has started to offer Roth conversions. And so when we think about whether we pay the tax now or whether we get the tax deduction and just keep growing the money pre-tax and eventually having to pay the taxes, that’s the decision between the two. And so a lot people are stuck in this decision of do I pay the tax now do I defer the tax until later? And that is something that makes it difficult to think about what do we do today in our paychecks versus what do we want to do later?

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Terry Gerton One more way of trying to offer people more options, I guess, but one more thing to think about as you’re trying to do all this comprehensive financial planning, why is Roth planning such a big deal then for federal employees?

Thiago Glieger The idea of deferring the tax is nice because you get to compound the money faster and you can not have to take three steps forward in putting the money and then one step back and withholding the tax so all of the money you put in there grows and builds faster for you with compound interest but the challenge is that eventually you are going to owe the tax on that money so that gift of tax deferral doesn’t last forever but the nice thing to then is usually because you’re not paying the tax. The salary that you’re earning gets reduced by the amount that you put into the TSP. So you don’t have to pay tax on all of your federal salary, which is very nice, particularly for people who are earning more because they’re later in their career or they have a position that’s paying a little bit better. So eventually, like we said, you take the money out and then you have to owe the tax. So you are always trying to figure out, does it make sense to commit to the tax right now, while I’m in whatever bracket that I am? Or, later when I’m not working and maybe I’m going to be in a lower tax bracket? So, committing to the tax now means putting money into the Roth. Committing to the tax later means putting the money in the traditional TSP now because later when you take it out, your money is going to be taxed. But with the exception of the catch-up contributions, this is a brand new thing this year, so everyone needs to remember that the catch- up contributions, if you’re over a certain amount of income, that’s still going to go in the Roth no matter what so you don’t get the break on the full amount.

Terry Gerton Well, as the old saying goes, nothing is certain except death and taxes. And you’re saying you’re going to pay taxes on this money one way or the other. If a federal employee is thinking about whether to include a Roth in their TSP, what are some of the top considerations?

Thiago Glieger Of the biggest considerations is to think about the diversification of the taxability of your money. We always talk about diversifying our investments, but having different taxable statuses is really nice because what if all of your is before tax or pre-tax traditional and then at some point you have to pay for a new car or you want to do a renovation in your house. Is all of the money that you own before tax and now you owe tax on top so if you have to buy a $30,000 car, the car might actually require $50,000 coming out of your TSP if you’re gonna buy the car. So having some money in different buckets, some that’s been taxed, some that not been tax yet, really helps give you flexibility. The other thing is to think about where you stand today in your bracket compared to the future. Like we mentioned earlier, if you are in your last 10 years of your career, chances are you’re probably earning the most money that you’ve earned so far, and you’re probably earning the most you ever will in your life over that last decade. And so you could probably use the tax deduction in those years and you should put money inside the traditional pre-tax versus if you’re early in your career and you still are building your wealth, building your income, well, maybe paying taxes in the Roth makes a whole lot of sense because you’re only going to be taxed more as time goes on.

Terry Gerton Thiago Glieger is a certified financial planner with RMG Advisors. Thiago, for people who started their TSP before Roth was an option, what should they be thinking about in terms of creating a mix here? Is that something that they should move forward with or maybe hold fast?

Thiago Glieger I think the idea of whether they should use Roth right now if they haven’t had the option before comes down to whether or not they believe they’re going to be in a higher bracket when they retire, the same bracket, or might they be in an actually lower bracket. So for example, if you are earning $150,000, what bracket does that put you in? Well, if your single versus married, it depends on your spouse’s income. But then if you compare that to what you need your lifestyle to look like in retirement, well, your federal pension is going to be taxed just like a salary or just like the pre-tax dollars and the TSP. Eventually, you’ll get some social security. So how much do you need to take out from your tsp to still be able to live your life? And how much total income does that figure combine to compared to where you are today? And if that number in the future is less than where you’re today then you might hold fast and not use the Roth yet because when you take the money out later, you’re gonna pay less taxes than if you pay for the Roth today. So even though you’ve not had a chance to contribute to the Roth all these years, I would still say in that situation, hold off a little bit. But someone who maybe is thinking that they’re gonna accelerate spending in early retirement, we call those the go-go years where you just have a lot of energy and you still wanna get out there and do a lot of things, more travel, more this, more that, you might find that your taxable income goes up some, maybe even more than where you are today, in which case you can look at the Roth as a good option for you today, even though you’ve not had it before.

Terry Gerton And then what about Roth conversions? They seem to be all the rage these days.

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Thiago Glieger Roth conversions are the rage for certain, and I think that is due to the fact that the TSP now offers Roth conversions inside the Thrift Savings Plan, where before that was not an option, you had to move the money to an IRA. So the idea is that you are voluntarily paying the taxes today. You had money inside the pre-tax account, you’re saying I’m gonna take $30,000 of that, and I’m going to pay the taxes on that, and I am going to move that $30,00 into the Roth, because I want that future growth to be completely tax-free. And it’s nice, except for the fact that you gotta pay the taxes. And so where is that tax money gonna come from? If you’re doing it in the TSP, TSP says you gotta come up with that outside of the TSP. If you doing it from an IRA, you can do it from withholding the actual transaction itself. So if you do $30,000, you can withhold back $6,000 or $7,000 or $8,000 however much in tax, and then the net difference goes to the Roth. So the idea again is that all of this future growth gets to be tax free and it helps for a lot of different reasons like RMDs and Medicare and all sorts of other things.

Terry Gerton And it also helps if your children inherit, right? They don’t have to pay taxes.

Thiago Glieger Yes, that’s right. And so the Roth, as of right now, and we believe it to remain the same way forever, will remain tax-free. And, so, the big challenge with kids inheriting retirement accounts is that they have to deplete it within 10 years. Sounds like you’re referring to the Secure Act, Terry. And the problem is that if you have to take the money out over 10 years, that’s a lot of income that gets taxed to the kids. So I tend to call this the child’s penalty. And so if they inherit a Roth instead, it makes it much easier for them to tolerate because they don’t have to pay any tax on that money.

Terry Gerton So as people are trying to think about their own balance of conventional IRAs and Roths, what are the most common mistakes you see people making and how should they avoid them?

Thiago Glieger When it comes to Roth planning, a lot of people believe that it’s an all or nothing approach and the truth is, just like again, we diversify investments, we wanna diversify the taxability of our money. It does make sense to defer taxes in a lot of situations as it does to pay the tax. So we don’t wanna do all or anything. The second I would say is where people tend to think about Roth in a silo and sometimes it’s not. I mean, Terry, you mentioned this idea of kids inheriting the Roth. Sometimes doing a Roth conversion is not for you. It’s for your family’s wealth down the line, so that they don’t have such high taxes during those 10 years. Other times, it’s simply for the fact that if you have an age gap between a spouse, if one of you dies early, the other falls to single tax rates. And now they have both their RMDs and your RMDs, and they might get pushed into a higher tax bracket. So I think that’s another situation. And then I think the last thing with Roth is just waiting too long. That’s the biggest mistake. People wait until they don’t have very many years, and you really wanna start doing that in your tax planning window, which is as soon as you retire, but before you start your RMDs.

Terry Gerton So that was my last question. When should people start thinking about doing this and actually making the move if they’re going to?

Thiago Glieger I think if we just think about when does it hurt the least to pay the taxes? It could be early in retirement because we’re in a low tax bracket. It could once we retire because now we don’t have any more income. Sometimes it’s even before filing for Social Security because remember if you stack your pension plus Roth conversions plus what you need to live plus Social Security, you start to fill that tax bucket pretty quickly. So think about, when is your bucket not going to be so full that you can take advantage of those conversions.

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