My friend Austin asked me about the Roth TSP. TSP is Thrift Savings Plan. It’s the equivalent to a 401k plan for federal government employees and members of the military.
Until now, TSP only accepts pre-tax contributions, like a Traditional 401k. TSP announced that it will add the Roth feature soon. I heard April 1, 2012 as the likely start date.
If you are in the TSP now, should you switch some or all of your contributions to the Roth TSP?
Federal civilian employees receive a full match if they contribute 5% of their pay. As a result, many just contribute 5% to get the full match. If they still contribute 5% but switch some or all of the contributions from pre-tax to Roth, because the Roth contributions and the earnings won’t be taxed after 59-1/2, these participants will have a higher retirement income after tax.
Switching to Roth sounds good then. But wait, a higher retirement income can also be achieved by simply increasing the contribution rate, from 5% to say 7%. So should you do 7% to traditional or 5% to Roth?
Private sector employees faced this question for some time now. Many employers added a Roth 401k feature to their 401k plan. The employees had the choice of switching to Roth 401k or bumping up their contributions to the Traditional 401k, because the impact on the take-home pay would be the same.
Like traditional 401k versus Roth 401k for the private sector employees, whether the Traditional TSP is better than the Roth TSP depends on the tax bracket now and the tax bracket in the future, which is unknown. In my previous post The Case Against Roth 401(k), I argued that most people should stay with Traditional 401k, except those who have a pension and already contribute the maximum.
However, for TSP participants, I say that most should switch to the Roth TSP.
Why the difference between private sector 401k and TSP? One word: pension.
Federal civilian employees do get a pension. The FERS program pays 1.1% of highest average pay during any consecutive 3 years for each year of service if you retire after 62 with 20 or more years of service (1% of high-3 average per year of service if under 62 or fewer than 20 years of service). For a 30-year service, that’s 33% of the pre-retirement income, covered. Social Security will cover another 1/3 of the pre-retirement income. Both FERS pension and Social Security are adjusted for inflation.
At retirement, withdrawals from the TSP will be taxed at the marginal rate, on top of pension and Social Security. For those who already contribute the maximum $17,000 a year to TSP, switching to the Roth TSP will effectively put more money into the TSP. You should lean toward doing the Roth TSP unless:
- You will not work long enough to qualify for a pension; or
- You have substantial income from other sources now (spouse, outside employment), which puts you in a high tax bracket; or
- You will retire early, but postpone drawing from your pension (use TSP withdrawals for gap years); or
- You live in a state with high state income tax but you will retire to a state with no or low state income tax; or
- an increase in Adjusted Gross Income will make you lose some other tax benefits (child tax credit, American Opportunity Credit, etc.)
Members of the military get a pension only if they stay in the military for 20 years. For those who will stay long enough to get the pension, the case for the Roth TSP would be the same as the one for civilian employees.
Military members who don’t stay 20 years won’t get a pension. I would still do the Roth TSP because the income in the military isn’t that high. After leaving the military, you will likely get a job in the private sector that pays much more. It makes sense to do the Roth TSP now when your tax rate is low.
With some exceptions, most TSP participants should switch to the Roth TSP.