Another huge mistake Federal Employees make with their TSP

The TSP introduced the Roth TSP in 2012. Unfortunately, there is still a lot of confusion about what the Roth TSP is and why it is a great option for many federal employees.

The Roth TSP is not a new investment option. It is an alternative tax handling of your TSP contributions. When you contribute to a Roth TSP, you pay taxes on the money you contribute – your contribution is “after tax”. By comparison, when you contribute to the traditional side of the TSP, your contribution is made “pre-tax” meaning that the amount you contribute is deducted from your paycheck before they calculate the taxes you owe.

Why would anyone contribute to a Roth on an “after tax” basis when they can contribute to a traditional TSP and get a tax deduction? When it comes time to take money out of a Roth TSP, you do not have to pay taxes on your withdrawals – whereas you do have to pay taxes when you take distributions from a traditional TSP.

So, the traditional TSP gives you a tax break now when you put money in, but you have to pay taxes when you take the money out. The Roth TSP does not give you a tax break now, but it is tax free when you take it out.

The decision to fund a Roth TSP comes down to whether you think you will be better off (in the long run) paying taxes today or paying taxes in the future. Let’s look at a few factors that might impact your decision:

Paying taxes on the seed vs. paying taxes on the harvest – which amount do you think will be greater, the amount you contribute today or the amount you withdraw in the future? If you assume that your TSP will grow at least minimally, then you will be paying taxes on a larger amount in the future with the traditional TSP than you will pay on today with a Roth TSP. Would you rather pay taxes on a larger amount or a smaller amount?

Will tax rates be higher in the future? Given the national debt that we have accumulated, many people believe that tax rates will go up in the future to help manage our debt. Even without the debt burden, tax rates today are relatively low compared to where they have been historically. Would you rather pay taxes today at a lower rate or in the future at a higher rate?

Paying taxes when cash is tight – when you retire, your budget is typically tighter than when you are working and bringing in a paycheck. When do you think it will be less strain on your budget to pay taxes, today when you are bringing in a paycheck, or in the future when you are living on a fixed income?

Lower tax bracket? Many folks believe that they will be in a lower tax bracket when they retire, but this is not the case as universally as people seem to think. Lost tax deductions (like mortgage interest) and dependents (the kids are finally out of the house!) can mean higher taxes. Your FERS / CSRS annuity, social security and TSP withdrawals are all taxable. You may not be in a lower bracket after all…

…especially if one of Washington’s favorite tax tricks comes into play. When people talk about “raising taxes” they usually look at the maximum tax bracket. If it increases, people say taxes are higher. If it does not increase, people consider taxes unchanged. But lawmakers love “stealth” tax increases – when they lower the thresholds for the lower tax brackets.

Here’s an example: in 2015, a couple can earn up to $18,450 in the 10% tax bracket. Then from $18,451 to $74,900 they pay 15%. So a couple with $60,000 in taxable income (after deductions and exemptions) would pay $8,077.50 in taxes:

10% of $18,450 = $1,845.00
15% of $41,550 = $6,232.50

$1,845.00 + $6,232.50 = $8,077.50

Now consider a “bracket shift” that capped the 10% bracket at $5,000, the 15% bracket at $50,000 and the 25% bracket at $125,000. Under the 2015 brackets, our couple did not have any income in the 25% bracket. But in the new brackets, they do:

10% of $ 5,000 = $ 500.00
15% of $45,000 = $6,750.00
25% of $10,000 = $2,500.00

$500.00 + $6,750.00 + $2,500.00 = $9,750.00

In this scenario, the top bracket may still remain at the current 39.6%, but the adjustments to the lower brackets, and the thresholds where tax rates bump up, requires our couple to pay $1,672.50 more in taxes – while the politicians can hide behind the unchanged maximum bracket and say they “did not raise taxes”!

The bottom line on taxes in the future is that a tax free Roth TSP will make the whole discussion moot!