Editor’s note: This is part 1 of a 3-part series on TSP investing.
The TSP is a valuable savings tool for all federal employees. This is especially true for those in the FERS retirement system, where the TSP serves as one of the three primary retirement income sources, along with the FERS annuity and Social Security. Utilizing it effectively is key to a comfortable retirement.
The first and most important factor that federal employees can control with regard to the TSP is their contribution level. Contributing at least 5% provides for the matching 5% from the government (for FERS employees), which should be considered a minimum level. Any contribution percentage less than 5% is giving up matching funds, and is also at a level that will be unlikely to provide the necessary retirement income. The maximum level for 2013 is $17,500 per year, plus a $5,500 catch-up for those people over age 50. Contributing the maximum amounts will provide the best odds for a more comfortable retirement, regardless of the actual investments chosen. The bottom line is that you should attempt to save as much as you can to improve your comfort level at retirement.
Many people are not able to afford to contribute the maximum amounts, but are still concerned that they are going to have a comfortable retirement. The first step in evaluating any particular situation is to review all potential income sources. After projecting your federal annuity, social security benefits, etc., you can work backwards to determine how much of your current take-home income will need to be made up by the TSP. After the income need is determined, you can work through an investment plan to get a feel for how much you will have to contribute to meet your goals. It is recommended that you go through this entire process with someone familiar with both the federal retirement system and financial planning. Once the planning is complete, you may find that you need to increase your contribution level.
One method of increasing your contribution level over time is to do so when it won’t affect your take-home income. For example, if you get a raise or step increase, you can increase your TSP withholding by the same percentage. Your budget would not change, but you are able to increase your contributions. The same concept can be applied if you are able to eliminate an expense from your budget. An example of this is paying off a vehicle loan and subsequently increasing your TSP contributions by the same dollar amount. This concept could also be applied to paying off a mortgage, no longer having child care expenses, or even dropping your landline phone. The amounts may seem small, but will have a large impact when accumulated over time.
Contributions can go toward the new Roth accounts or the regular pre-tax TSP. Roth accounts vary from the standard TSP in that the contributed funds are after-tax, rather than pre-tax. Roth accounts are not taxed at retirement, however.
The decision on whether to utilize the Roth option should be addressed on an individual basis, factoring in income, age, current balance, etc. Recent legislation has also allowed for the potential future possibility of converting existing standard pre-tax savings to the Roth account. This should also be considered on an individual basis if it is implemented. The decision regarding the Roth account can have a dramatic effect on the future taxation of your retirement, and should be given careful consideration. If you’re not sure how to evaluate it, get help from someone who is familiar with the issues involved.
Dollar Cost Averaging
“Dollar cost averaging” is a common investment term, and refers to the practice of making consistent dollar amount investments over time. The benefit of this approach is that during a market downturn, you continue to buy into the funds at reduced prices. When they rebound to pre-downturn levels, you would then have made a return on that new money, rather than stay flat. This level contribution concept is somewhat automatic when contributing to TSP, and it is recommended to stay with a level contribution, rather than starting and stopping contributions with market movements.
The TSP is a very cost-effective investment vehicle, and offers well-diversified options for the federal employees that utilize it. There are, however, some occasions when accounts outside of TSP may make sense. The detailed scenarios are beyond the scope of this article, but you may consider investigating further if one of these situations applies to you:
- Transferring TSP to an IRA to gain withdrawal flexibility in retirement
- Transferring TSP to an IRA to gain control of whether withdrawals should come from the pre-tax or Roth accounts (current TSP distributions will come proportionally from each, with no option to select levels)
- Saving in an IRA for the purpose of investing a small portion of the portfolio in options not available within TSP, such as real estate, gold or precious metals, oil, etc.
- Saving in an account outside of TSP to build up an accessible emergency fund
- Saving in an account outside of TSP to build up a fund for the first few years of retirement, when TSP withdrawals would be subject to early withdrawal penalties (retiring before the calendar year you turn 55)
- Saving in an account outside of TSP in order to save more than the maximum allowed in TSP.
Are You On Track?
Many federal employees question whether they are saving enough, and on pace for their planned retirement. The answer depends on the individual situation, but it can be helpful to consider an example for comparison. The following is a theoretical scenario, in which percentages will be used that could apply to any salary.
- 62 years old and 30 years of service at retirement (at some future date)
- FERS annuity will provide 33% of gross income
- Social Security at 62 will provide approx. 20% of gross income (can vary greatly)
- 10% of salary contributed to TSP for all 30 years, plus 5% matching
- Salary increased at a rate of 3% per year over career (including raises and step increases)
- TSP earned a return of 7% for entire career
- TSP withdrawn at an initial rate of 4% in retirement
- TSP account value after 10 years: 1.75 times salary at the time
- TSP account value after 20 years: 4.5 times salary at the time
- TSP account value after 30 years: 8.25 times final salary
- TSP income provided at retirement: 33% of final salary
The numbers used in this example will vary based on many factors, such as age, length of service, regular raises, investment returns, etc. Changes in returns, for example, can have a significant effect over time. The example is useful, however, to give you a feel for the power of the TSP as a component of your retirement income. In this situation, with 33% of the final salary coming from the FERS annuity, 20% from Social Security, and 33% from the TSP, 86% of the final salary is replaced. Considering that the 10% TSP contribution is no longer withheld and FICA taxes are no longer paid, this example provides a higher take-home income in retirement than while working.
Those employees who will be retiring sooner or with less service time will need to target higher TSP balances earlier on to maintain the same level of income. Please consider your own situation in its entirety before making an evaluation of your progress.
The best place to start if you are considering your contribution levels is to put together an actual retirement plan, and use that to drive the rest of your decisions. For federal employees, that starts with a complete analysis of the federal benefit package, and what to expect from it in the future. Once you have an overall plan, you will be able to see what portion of your retirement that TSP will need to cover. You can then set an appropriate goal and, with that goal in mind, work backwards to determine what combination of contributions and investment returns will be necessary to reach it. Once you know what you need to do, you can begin the process of getting there.