Pay Taxes on the Seed, Not the Harvest

One advantage federal employees have when saving for retirement is the Roth TSP. A Roth investment allows you to pay tax on the seed (the smaller, starting investment) and reap the bounties (the investment plus growth/interest) tax-free. The author explains more about how this works.

Autumn is the season when farmers all over harvest their crops.  How rewarding it must be for them to start from a small seed, to water and feed it and watch it grow, and then to reap the bounties that their hard work has produced!

The same can be said for all of us as we plan for retirement… we start with a seed, watch it grow over time and then as we enter retirement with the intent to reap the bounties of our growth – only to find out that the IRS has a right to a part of it!

One of the great advantages you have is the Roth (TSP and IRA).  A Roth investment allows you to pay tax on the seed (the smaller, starting investment) and reap the bounties (the investment plus growth/interest) tax-free!

There are two distinct ways that Federal Employees can take advantage of Roth Investments:

  1. Roth TSP
  2. Voluntary Contribution Plan (VCP)

Roth TSP

Since 2012, federal employees have been able to contribute to a Roth TSP as well as to the traditional model. As is the case with a Roth IRA, participants who choose the Roth TSP make after-tax contributions and eventually can take tax-free distributions, after five years and after attaining age  59½.

Planning guidelines for the Roth TSP are similar, too. The more years of tax-free buildup you can expect and the greater the chance of retiring in a high tax bracket, the more appealing the Roth side will be.

However, the Roth TSP differs from a Roth IRA in the taxation of distributions. If you have both a traditional and a Roth balance in your TSP account, all withdrawals will be taken proportionally from each side.

Example #3: Gloria has $75,000 in her traditional TSP and $25,000 in her Roth TSP. If Gloria withdraws $10,000 from her TSP account, her withdrawal will be treated as $7,500 from the traditional version and $2,500 from the Roth.  If Gloria had rolled over her traditional TSP to a traditional IRA and rolled over her Roth TSP to a Roth IRA, Gloria could pick and choose between the two accounts. She might take a partial distribution from her traditional IRA to fill out her tax bracket, for example, and then complete her desired withdrawal from her Roth IRA, potentially tax-free.

Many federal employees already have traditional TSP balances.  If so, you should seek advice on how Roth TSP distributions will be treated, if you are considering the Roth version.

Voluntary Contribution Program (VCP)

In addition, federal employees in the CSRS have an opportunity to create a large Roth IRA, tax-free. This opportunity is open only to current federal workers in the CSRS who can put money into the little-known VCP, the Voluntary Contribution Program. The VCP accepts after-tax contributions, up to 10% of your lifetime federal earnings, and the money goes into a fixed account earning a low yield now.  Some veteran federal employees have lifetime earnings of $2 million or more. For these federal employees, six-figure amounts can be moved (converted) into a Roth IRA, tax-free.

Example #1: Dawn Simmons, age 60, has lifetime federal earnings of $2.3 million. Dawn can move $230,000 from an after- tax brokerage, bank or other account into the VCP. After this contribution, Dawn can immediately transfer the $230,000 into a Roth IRA. Then she can invest that money any way she wishes. There is no pro-rata rule to worry about here, but more on that in a bit.

After five years, Dawn can withdraw from her Roth IRA as much or as little as she wishes, whenever she wants, tax-free. Even prior to the 5-year mark Dawn will have a significant amount of flexibility. Since she’s already over 59½, her converted amounts (roughly $230,000) can be withdrawn at any time tax and penalty free.

Key VCP-to-Roth Items

In order to execute such a transaction, the VCP contribution must be made while the participant is still working. Waiting until retirement voids their eligibility. For federal employees who are interested in this opportunity, there is no point in waiting. While you are still working – even if you are a few years from retirement – you can make after- tax contributions to the VCP.  By immediately converting to a Roth IRA, you will avoid accumulating interest in the VCP, so there’s no tax on the Roth conversion. VCP participants can also roll any earned interest into a TSP account and thus avoid any taxes on a Roth IRA conversion.

You can make VCP contributions in a lump-sum or spread out the contributions over a period of years.  Contributions can be made by check or through a scheduled electronic bank draft, and must be in multiples of $25. If you have taken any money from the CSRS, that amount must be re-deposited before VCP contributions are permitted.

Determining the allowable amount to contribute and setting up the accounts may take time, so this should be done some time before your actual retirement date.

In addition, the Federal Office of Personnel Management (OPM) is currently on overdrive trying to process retirement paperwork for government employees eager to get their pension checks.  Establishing VCP accounts does not appear to be a high priority for OPM, or perhaps the agency is not properly equipped to take on the daunting task of processing retirement paperwork. Therefore, it is crucial for federal employees who intend to establish Roth IRAs in this manner to be aware of the time constraints.

If you would like more information about the Roth TSP or how to use the VCP to your advantage, please feel free to contact our office and we can walk you through the steps.

About the Author

Carol Schmidlin, Certified Financial Fiduciary®, MRFC® is the President of Franklin Planning and has been advising clients on how to grow and preserve their wealth for 25 years. In addition to her financial planning practice, she is the founder of FedSavvy® Educational Solutions, which provides Financial and Retirement Literacy Programs for Federal Employees. She is passionate about helping families with all phases of Wealth Management and is a member of Ed Slott’s Master Elite IRA Advisor Group. Her practice maintains a home office in Sewell, NJ along with a satellite office in Washington, DC. Carol can be reached at (856) 401-1101.