“I watched the very helpful video on ROTH IRA conversions. I will be retiring by the end of 2022 and I do not have any funds in the Roth TSP, but all funds have been in the traditional TSP. In hindsight, that was probably not a good idea. I am now wondering if there is any upside to having all or some of my 2022 contributions placed in the Roth TSP. Also, if I do this can these funds now be TRANSFERRED to a Roth IRA when I retire? ” – Deborah.
We get asked all the time whether or not to contribute to the Roth TSP. It’s a great question, but we first need to understand how the Traditional TSP works and compare it to how the Roth TSP works.
The normal or “Traditional” TSP is where you put in pre-tax dollars, which means it gets deducted from your paycheck without any taxes taken out first. It then grows tax-deferred, meaning you can make changes to the funds you are invested in without paying any taxes. It’s only until you start taking out distributions that you’ll have to pay income taxes on that money.
On the other hand, Roth TSP contributions are the complete opposite of Traditional contributions. Taxes are taken out first, and contributions are made to the Roth TSP with after-tax dollars. It grows 100% tax-free inside the Roth TSP, meaning that you will not pay any taxes again when you take distributions out in retirement.
So why would you want to do Roth TSP contributions versus just doing Traditional contributions? The first thing we want to look at is the current tax laws that we are in today; big changes are coming in just a few years. The Tax Cuts and Jobs Act (TCJA) which was enacted in 2017 is set to sunset in 2025. This means that by the tax year 2026, the tax law as it is written today will revert back to the tax brackets that were in place prior to the TCJA, and simply put, taxes are going up. So if we know taxes are going up in the future, it might make sense to intentionally pay taxes at a lower rate today in the form of Roth TSP contributions.
But that’s not the only reason to do Roth TSP contributions. Another reason has to do with tax diversification. Tax diversification is a strategy that involves having different types of investments with varying tax treatments. The goal is to have a mix of taxable, tax-deferred, and tax-free accounts so that you can manage your tax liability and maximize your after-tax returns.
If you look at your sources of income in retirement, you will have your FERS pension and eventually Social Security, and both of these are taxable. So by diversifying your investments across different tax treatments, and in particular Roth TSP, you can reduce your overall tax risk and minimize the impact of any changes in tax laws or rates.
We’re big fans of Roth TSP as well as Roth IRAs. That doesn’t mean that we are recommending you switch 100% from Traditional contributions to Roth. It is important to look at your individual tax situation to see what is going to make the most sense. If we switched cold turkey from Traditional contributions to Roth, that just increased your tax liability for the year. Maybe this puts you in a higher tax bracket that you normally wouldn’t be in. Or maybe you forgot to increase your tax withholdings, and now you will owe more money when you file your taxes the next year.
So while we think Roth TSP contributions are a powerful tool, you have to consult with your financial advisor or tax professional on it to see what is going to make the most sense in your situation. Maybe that means moving a smaller percentage of your contributions at a time over to Roth. Or if you aren’t maxing out the TSP contributions just yet, maybe that means that any new contributions will go to Roth as this won’t affect the taxes that you are currently paying.
As always, happy planning!
