“I am a retired FERS federal employee (age 65). I just watched your episode about a “like kind direct transfer” of tsp funds to an IRA, and then the subsequent transfer from the newly opened IRA to a newly opened ROTH IRA. My question: Using your example amount, if I transferred $10,000 from the newly opened IRA to the newly opened ROTH IRA, the taxes that would be owed on $10,000 ROTH transfer amount would have to come from another cash source? Asked another way, can the taxes owed on the $10,000 transferred to the ROTH be paid out of the 10K and the ROTH set up with the after-tax money? Or, do I have to pay the taxes from other cash sources, so the full 10K is transferred into the newly opened ROTH IRA?” – Dennis
Types of Taxation Federal Employees have
If you listen to our Federal Employee podcast or watch our educational videos on YouTube, you know that we have said one thousand times,
“Cash flow is king but tax planning in retirement will make or break a retirement plan.”
Federal Employees must have a 5 to 10-year tax plan in place so that they know how they will control their taxable income in the future.
We love talking about tax planning because this is where financial planners who serve Federal Employees, we can help our clients really understand the power of their decisions when it comes to withdrawing money from their retirement accounts.
As a Federal Employee, you have four different tax buckets to think about:
One of the greatest advantages of being a federal employee is that you can contribute via payroll deductions to your Thrift Savings Plan. We love the TSP around here because it makes planning for retirement easy to navigate and low-cost to manage investments. One of the benefits that you have as a federal employee is to contribute to your tax-deferred retirement account within the TSP.
Your tax-deferred retirement account allows you to contribute funds today and defer those taxes until later when you withdraw them. When you defer taxes, you’re not paying any income tax on the money. Instead, you’re waiting until the time that you take your money out of the account to pay taxes on the funds at whatever tax rate that you’re in at that time.
During his working years for the Feds, someone like Dennis may have contributed to the traditional TSP which is tax-deferred to reduce his taxable income. After all, your working years are often your highest income years so reducing your taxable income can be advantageous.
When Dennis goes to retire though and makes a distribution from his tax-deferred account, he has to pay taxes on those funds at whatever tax rate he is at when he withdrawals the funds. In retirement, we assume that our taxes will be lower.
Lower taxes in retirement is not always a guarantee.
Not only can tax law change, adjusting the amount you pay in taxes but you could also have other factors like whether or not you choose to work after you retire from federal service to consider.
These are all important factors when it comes to building your retirement tax plan because so much of your retirement, as a federal employee, is still taxable.
What parts of your retirement are taxable under FERS:
- Your pension less your contributions.
- Your social security less your contributions.
- Your thrift savings plan distributions from your traditional account.
Oh and keep in mind that while you are working, your health insurance under Federal Employee Health Benefits was made pre-tax. When you retire, that is not the case.
Is the TSP a Future Tax Problem?
The TSP is a phenomenal accumulation tool while you are working to put money aside from retirement. Your pension from federal service may not be enough to financially support you for the rest of your life. Therefore, the TSP allows you to put aside funds earmarked for your retirement.
As the Traditional TSP grows though, so does your tax liability.
At some point, when you withdraw funds from your traditional TSP, you have to pay taxes. The withdrawal that you make is considered taxable income in the year that you make the withdrawal.
The TSP office does not know what your tax rate is each year, only you do. They will assume that you need to withhold at least 20% for taxes but the reality is, that is their best guess. If you are in a 15% tax bracket, you may get a refund when you file your taxes for overpaying. If you are at a 28% tax bracket, you may owe more for your withdrawal than you originally anticipated. Tax Planning is critical to the longevity of your retirement plan.
Our favorite tax bucket (and you may find it is yours too!) is the Tax Free bucket. How do you put money in an account that is tax-free in the future?
The ROTH is a great example of a tax-free account or “bucket” for retirement funds.
To address Dennis’ question we will be talking about the ROTH Individual Retirement Arrangement (IRA) and NOT the Roth component in the TSP.
How to pay taxes on a Roth Conversion from your TSP
Like many federal employees, Dennis most likely put the bulk of his TSP contributions into the tax-deferred account within the TSP. Over time, it’s experienced growth and now his contributions and earnings are all waiting for him to make a withdrawal so that he can pay taxes.
Oh Aunt IRS… you never miss a meal. 🙂
For example, let’s say that Dennis had $500,000 in his traditional TSP. He opens an IRA and transfers $100,000 from his TSP to his IRA.
This is a tax reportable event but not an income taxable event. The IRS wants to know what you’re doing with the money that they have not taxed yet. An IRA is a tax-deferred account.
Dennis opens a ROTH IRA, a tax-free account.
Dennis wants to move $10,000 from his IRA to his ROTH IRA, an income taxable event.
When you move from one tax bucket to another, you have to pay taxes normally.
Dennis wants to move $10,000 because not only is his contribution tax-free in the future but so are the earnings. As the investment (hopefully) grows, his earnings will be tax-free when he withdrawals the funds later providing he has met the guidelines for having a ROTH IRA, like having the account open for 5+ years.
Remember though, when Dennis moved his money from the tax-deferred account to the tax-free account, he has to pay taxes on the funds he took out.
There are two ways that Dennis can accomplish paying taxes on his ROTH conversion. This is a hypothetical scenario since we do not know Dennis actual tax bracket or his gross income:
Dennis could contribute $9,000 to his ROTH IRA and send $1,000 to the IRS immediately.
Dennis could contribute $10,000 to his RTOH IRA and from another source of funds, send the IRS $1,000. This way he is putting the most amount of money into the ROTH IRA so that it has the potential to grow tax-free.
ROTH Conversions are so powerful to understand. We talk with our federal employee clients almost every year about them because we want to look for advantageous times to tax advantage of conversions. Situations like declining markets, job changes, reduced incomes, etc.
However, there are a lot of technical nuances that you have to understand before attempting a ROTH Conversion. For example, you cannot and should not try and go from the TSP directly to a ROTH. Rather, you need to go from the TSP to an IRA and then to a ROTH IRA. You also need to factor in ALL of your taxable income for that year. Often, we see this go wrong when someone prematurely does a ROTH conversion and then later in the year, realizes that their taxable income was greater than expected.