Edward A. Zurndorfer–
The Thrift Savings Plan (TSP) is an extremely important part of a federal employee’s retirement, especially employees covered by the Federal Employees Retirement System (FERS). Employees are therefore encouraged to evaluate their TSP accounts throughout their federal service to make sure they are getting the most of what the TSP can offer for their retirement, but especially when they are in mid-career. This column discusses what mid-career employees should be doing with respect to evaluating their TSP accounts and planning for what they will do with their TSP accounts during their retirement. Included in the discussion will be: (1) How much employees should be ideally contributing to the TSP each year; (2) why employees should recognize that the TSP is a “long-term” savings plan and implications on how employees should be investing in the TSP; (3) which type of TSP account employees should be contributing to; namely, the traditional (“before-taxed”) TSP or the Roth (“after-taxed” TSP), or perhaps both accounts; and (4) why employees should be thinking now about what they plan to do with their TSP accounts after they retire from federal service.
How much should employees be contributing to the TSP?
There are several reasons that a federal employee should take full advantage of the TSP and therefore contribute the maximum possible to the TSP each year. First, while employees have other ways to save for their retirement such as contributing to an IRA or purchasing a nonqualified annuity, contributing to the TSP is unique because: (1) An employee can contribute to the TSP only when he or she is in federal service. Contributions to IRAs can be made if an employee leaves federal service and gets a job in private industry or becomes self-employed. A nonqualified annuity can be purchased even if an individual is not employed; and (2) the traditional TSP offers current-year tax savings. All employees can contribute to the traditional TSP and reap the federal and state tax savings associated with traditional TSP contributions. Most federal employees are not eligible to contribute to a traditional deductible IRA. Also, many federal employees are not eligible to contribute to a Roth IRA because their income is too large. On the other hand, the Roth TSP has no income limitation with regard to contributions and any employee is eligible to contribute to the Roth TSP.
With this information in mind, employees should make it their goal to maximize their TSP contributions each year. For 2020, all full-time and part-time permanent employees can contribute a maximum $19,500 to the TSP if they are under age 50 as of Dec. 31, 2020; $26,000 ($19,500 plus $6,500 “catch-up” contributions) if they are over age 49 as of Dec. 31, 2020. At a minimum, FERS-covered employees should contribute at least five percent of their salary each pay period in order to receive the maximum matching contribution of four percent from their agencies. Note that employee contributions must be deducted from an employee’s paycheck. A FERS-covered employee’s agency automatic one percent of gross pay contribution and agency matching contributions (maximum four percent match) is also not part of the $19,500. The agency matching contribution should be considered as “free money”. Therefore, a FERS-covered employee who is contributing less than five percent of his or her salary each pay period is in a sense, “leaving money on the table.” An employee can increase his or her TSP contributions, start or resume “catch-up” contributions at any time. Most federal agencies allow employees to change their TSP contribution amounts via an electronic enrollment process.
Why Employees Need to Recognize the TSP as a “Long-Term” Savings Plan and Invest Accordingly
The TSP is a “long-term” savings plan that a TSP participant will need to have access to throughout his or her retirement years. “Long-term” is defined as between now and the time an employee/retiree no longer needs a TSP account which, unfortunately, is at the time of the death of the employee/retiree (and a loved one such as a surviving spouse who will also need income from the TSP). As such, a TSP participant needs to make sure that by the time the TSP participant retires from federal service, the participant has the largest possible TSP account. To have the largest possible TSP account at retirement, a TSP participant should be: (1) Contributing the maximum possible via payroll deduction; and (2) keeping “growth” in mind as an investment strategy during the years he or she is contributing to the TSP and even during one’s retirement years when TSP contributions are no longer permitted. That means a TSP participant must make sure that his or her TSP account grows now and continues to grow in value throughout one’s retirement years. How does a TSP account grow over time? By investing the majority of one’s TSP account in the three TSP stock funds – the common stock or “C” fund, the small-cap stock index, or “S” fund, and the international stock index, or “I” fund. Investment studies have shown that stocks over the years have outperformed almost all other types of investments. While past investment performance is no guarantee of future investment performance and there is always the investment risk associated with stock investing, employees must not forget the investment risk/return relationship. In particular, if an investor is willing to undertake the risk associated with stock investing, then the investor could be rewarded with a higher investment return, as stock investors have seen over many past years.
Another point to consider: Federal employees can in reality really afford to undertake the risk associated with stock investing because when they retire from federal service, employees have a guaranteed pension in the form of a CSRS or FERS annuity. But federal employees cannot afford to not take this investment risk because the real risk that retirees of today and in the future have to be concerned with is longevity risk. Longevity risk means outliving one’s retirement savings, which could happen if a TSP participant were to withdraw his or her account at a higher percentage rate compared to the investment percentage return that the TSP assets remaining in the account are earning. For this reason, even during their retirement years, federal employees are highly encouraged to keep the majority of their TSP accounts invested in the three stock funds. In so doing, they lessen the risk of “outliving” their TSP account.
Which TSP Account – the traditional TSP or the Roth TSP (or both)- Should Employees be Contributing to?
As explained previously, during calendar year 2020 an employee can contribute a maximum $19,500 (“regular” contribution) to the TSP and if the employee is over age 49 as of Dec. 31, 2020, a maximum of $6,500 in “catchup” contributions can be contributed to the TSP for a total of $26,000. These contributions can only be made via payroll deduction every pay period.
Employees have a choice as to which type of TSP account they can contribute to, namely: (1) the traditional TSP in which contributions are deducted from an employee’s gross salary before federal and state income taxes are withheld. Any type of earnings within a TSP participant’s traditional TSP account (that is, interest, dividends, capital gains) grow tax-deferred. A traditional TSP account is only subject to federal and state income taxes when a TSP participant withdraws his or her traditional TSP account; (2) the Roth TSP in which contributions are deducted from an employee’s after-taxed salary (after federal and state income taxes are withheld). Any accrued earnings in the Roth TSP account will grow at least tax-deferred. However, if a Roth TSP participant makes a “qualified” Roth TSP withdrawal – the Roth TSP participant is over age 59.5 and it has been at least five years since January 1 of the year the Roth TSP made his or her very first Roth TSP contribution – then the entire Roth TSP withdrawal consisting of after-taxed contributions and accrued earnings (which have not been taxed) will be federal and state income tax-free.
With this information in mind regarding the tax treatment of the traditional TSP and the Roth TSP account, the question for an employee who is mid-career needs to ask himself or herself: Which TSP account is better for me? Here are some helpful points for employees to consider: (1) As a starting point, an employee should look at his or her 2018 and 2019 federal income tax returns. These returns are the first years that were subject to rules of the recently passed Tax Cuts and Jobs Act of 2017 (TCJA). TCJA reduced individual marginal tax rates but only for the years 2018 through 2025. If the employee had a significantly large balance due (more than $1,000) when the 2018 and 2019 federal income tax returns were filed, then the employee should consider contributing more to the traditional TSP in order to decrease their federal income liability; (2) an employee who received a significant refund (more than $1,000) on the 2018 and 2019 federal income tax returns should consider contributing more to the Roth TSP. The virtues of the Roth TSP will be discussed in more detail in the last section; (3) if an employee expects to be in a larger combined federal and state marginal tax bracket at the time he or she withdraws his or her TSP account compared to his or her combined federal and state marginal tax bracket at the time he or she contributes to the TSP, then the Roth TSP is a better choice. If the opposite is true, then the traditional TSP is the better choice; (4) if an employee is still eligible to contribute to a Roth IRA (note the Roth IRA has adjusted gross income limitations in order to contribute), then the employee should contribute separately to a Roth IRA (a Roth IRA must be opened separately) and not contribute at all to the Roth TSP. Instead, all contributions should go to the traditional TSP. When the employee is no longer eligible to contribute to a Roth IRA because the employee’s adjusted gross income is too large, at that time the employee should contribute to the Roth TSP. Upon retiring from federal service, any funds in the Roth TSP account can be directly transferred to the employee’s Roth IRA with no tax consequences; and (5) an employee can contribute to both the traditional TSP and the Roth TSP provided the employee’s total contributions do not exceed the year’s maximum (2020 – $19,500 “regular” contributions; $6,500 “catch-up contributions. However, for FERS employees, no matter which TSP account a FER employee contributes to, the employee agency’s automatic (one percent of gross pay) and matching contributions will be contributed to the employee’s traditional TSP account. No agency contributions will go to an employee’s Roth TSP account.
Why Do Employees Need to be Thinking About What They Plan to do with their TSP Account after they Retire from Federal Service?
Upon retiring from federal service, an employee has to decide what he or she wants to do with his or her TSP account. There are several options including leaving it alone, making withdrawals and making transfer to IRAs and to other qualified retirement accounts. Over the 12 months, two events have resulted in the expansion of changes to TSP withdrawal opportunities for TSP participants. The first event was in September 2019 when the TSP implemented expanded and more flexible withdrawal options. The second event was the passage of the SECURE Act in December 2019 that, among other things: (1) Delayed the required beginning date (RBD) for retired TSP participants from April 1 following the year the participant became age 70.5 to April 1 following the year the participant becomes age 72. Note that the new rule applies to TSP participants born after June 30, 1949; and (2) for non-spousal beneficiaries of TSP accounts who elect to directly transfer their inherited TSP accounts to inherited (“death”) IRAs, the non-spousal beneficiary must withdraw all inherited IRA assets within 10 years of the original TSP participant’s death. Before the SECURE Act passage, a non-spousal beneficiary could withdraw the inherited IRA assets over his or her remaining lifetime.
With regard to expanded TSP withdrawal options under the new TSP rules, after he or she retires from federal service a TSP participant can make multiple transfers of his or her traditional TSP account to a rollover Roth IRA. While this is a taxable event, if done the correct way, a traditional TSP participant could make multiple (but no more than 12) transfers per year to a Roth IRA in a way so as to not push the TSP participant into a marginal higher tax bracket. This can be accomplished over a period of time, ideally before the participant becomes age 72 but should only be done by working with a professional tax accountant after the participant has retired from federal service. Transferring one’s traditional TSP account to a Roth IRA makes good sense because, among other reasons, by transferring one’s traditional TSP account into a Roth IRA, the TSP participant will not have to worry about TSP required minimum distributions (RMDs) because the Roth IRA is not subject to RMDs.
If a TSP participant has a Roth TSP account, then once the participant retires from federal service, he or she is also encouraged to directly transfer his or her Roth TSP to a Roth IRA. This is not a taxable event. In so doing, the Roth TSP participant will then avoid having to take Roth TSP RMDs.
With regard to the SECURE Act, TSP participants in mid-career with sizeable TSP accounts and who have named non-spousal beneficiaries (such as adult children) of their TSP accounts should consider contributing more to the Roth TSP. When they retire and assuming they will not all of their traditional TSP accounts to help pay their bills during their retirement years, they should consider transferring part of their traditional TSP account to Roth IRAs over a period of time. The reason is that upon their death, any non-spousal beneficiary must withdraw inherited TSP assets within five years of the death of the TSP participant. The non-spousal beneficiary must pay full federal and state income taxes on inherited traditional TSP assets in the year received. With individual income tax rates expected to increase after 2025, the traditional TSP non-spousal beneficiaries, (such as adult children) will likely pay a huge amount of federal taxes. If the non-spousal beneficiary directly transfers the inherited traditional TSP assets to an “inherited” traditional IRA. Then under the SECURE Act, all inherited traditional IRA assets must be withdrawn within 10 years of the death of the traditional TSP participant. Once again, there could be a huge federal tax liability.
While the same withdrawal rules apply to the Roth TSP and to the inherited Roth IRA, at least the non-spousal beneficiary will not have to pay any tax upon the withdrawing of the inherited Roth assets. With tax rates expected to increase in the next five year, this should be a major consideration for federal employees in mid-career as they comprehend what will happen to their TSP accounts following their retirement from federal service
Edward A. Zurndorfer is a CERTIFIED FINANCIAL PLANNER™ professional, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street – Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.