National DEAF-icit: Debt, Taxes, and Your Retirement

The author says that taxes are likely to be higher in the future when current federal employees are at or nearing retirement. He outlines some options available to federal workers to help offset future tax burdens.

Politicians from both parties have turned a deaf ear to concerns about the long-term impact of our astronomical National Debt.

Now this is not a political piece discussing party principals or pointing fingers, rather a cold splash of water to the collective face of the federal workforce to help you understand how to leverage the tax proposals of the new regime to improve your retirement outlook.

Regardless of which side of the political isle you sit on, in the last decade it seems that the only bipartisan agreement has been to increase the National Debt. Our National Debt is argued by many, such as former Comptroller General Hon. David Walker, to be the single greatest threat to our national security! The President Elect is looking to reform the bloated tax code, cutting most income tax rates, while simultaneously infusing Government funds into rebuilding the American infrastructure. There is ample justification for both actions but the combination will add trillions more to our National Debt. Mathematically speaking, the cost of our preexisting debt already insures that this proposed period of additional tax relief will come with an expiration date.

Understand the Problem

Our National Debt is $19.8 trillion, up from just $9 trillion before the financial crisis. Early estimates show the President Elect’s plan adding $5.3 trillion to the National Debt. That is not including any plans to save the Social Security Trust Fund, the Medicare Trust Fund, and the Interstate Highway Trust Fund – which are all on pace to run out during the Baby Boomers’ retirement. So how can we afford to increase spending and decrease revenue (taxes)?

The answer is that we cannot afford to do so for long! The financial alchemy (pronounced Qualitative Easing) that has largely contributed the US economic “recovery” is already now a debt burden too big to be paid off by one generation. Our National Debt is like a credit card with an introductory 0% APR promotion. The cost of our debt is going to rise when the Fed’s unprecedented 0% interest rate inevitably normalizes. When that happens, the interest payments that Uncle Sam owes on our pre-existing National Debt will increase dramatically without any new benefits to show for the added annual expense. Just like interest payments on credit card debt, we are going to pay more tomorrow for what we already enjoyed yesterday with nothing new to show for it!

Understand the Impact

The good news is that tax relief would be the short-term tangible result of this proposal. The bad news is that it is fiscally unsustainable so you had better learn how to leverage these rules to protect your retirement while you can!

For most Feds, nearly 100% of your FERS/CSRS pension, up to 85% of your FERS Supplement, up to 85% of your Social Security, and 100% of your Traditional TSP are forever taxable as income at whatever rate Uncle Sam fancies. Recognize the risk this creates! Today the highest income tax bracket pays 39.6%, in 1963 the highest bracket paid 91%! There may be no changes for decades, but a single income tax spike 20 years from now would still devastate the rest of your retirement!

Understand the Solutions

Now there are only a finite number of financial tools available to protect your nest egg from higher future tax rates, all of which are strictly governed by the IRS and intentionally have contribution limits to regulate participation.

Consider funding the Roth TSP

The only difference between the Traditional TSP and Roth TSP is the tax treatment – both have the same investment options and incredibly low fees. In the Traditional TSP you make qualified contributions that utilize pre-tax funds, the Roth TSP simply uses after-tax dollars. It is important to work with a Federally Focused Financial Advisor to discuss the ramifications of the TSP “Pro-Rata Rule” as you develop your investment plan. This rule states that your TSP distributions must be proportionally taken from the Traditional TSP and Roth TSP accounts – eliminating your ability to control the tax treatment of your disbursements. You and your financial coach need to make sure to put a plan in place for how to position your portfolio to maintain control of the tax treatment of your disbursements.

Recognize how lower rates impact a Roth Conversion of your IRA or Traditional TSP

A Traditional TSP cannot internally be converted to a Roth TSP so converting your Traditional TSP actually requires the additional step of transferring the funds from the Thrift Savings Plan to an IRA and then converting that IRA to a Roth IRA. That conversion is a taxable event that has many potential implications and caveats. Work with a professional to build a plan that minimizes penalties, manages your income tax bracket, and follows the IRS guidelines.

Finally, if you are CSRS, then it is imperative that you review the “Voluntary Contribution Program”

The VCP allows you to bypass Roth contribution limits and immediately establish a supercharged Roth IRA equal to as much as 10% of your career earnings! This strategy MUST be implemented BEFORE RETIREMENT and is only available to CSRS employees. There are precious few Feds that both qualify for the program and are also financially equipped to take advantage of it and there are even fewer Federally Focused Financial Advisors that know how to properly implement this incredible benefit. It will take an in-depth discussion to cover this topic in sufficient detail, so for those of you that are CSRS, are still employed by the government, and have accounts with non-qualified funds in them it is absolutely imperative that you review this incredibly powerful benefit with a financial coach!

Also consider the multifaceted use of Cash Value Life Insurance to protect you, your family, and to grow tax free wealth

Life Insurance, when implemented properly, protects you during your lifetime through the use of Living Benefits, it protects your family in the event of your passing with the most tax efficient legacy available, and can internally grow cash value that you can access tax-free!

Understand the Result

You can eliminate the risk of higher future taxes by paying tax on the seeds today rather than the harvest in retirement. Those who’s effective tax rates are being lowered can lock in additional savings as well. Imagine you deferred taxes at 39.6% last year, then pay them next year at the proposed 33%. Thats an immediate 6.6% savings – but if your tax rate later rose to say 45% in retirement your savings increase dramatically! These strategies generate supplemental revenue that does not show up on your 1040 tax return as income – which can lower the amount of your Social Security Benefit (or FERS Supplement) that is taxable and can further lower the tax liability faced on your other income streams.

Taxes are going to be on sale for a limited time and leveraging that sale to your advantage can have immeasurable impact on improving your long term financial security. For many Feds this temporary tax relief may well be the opportunity of a lifetime – but you must take advantage of it during the lifetime of the opportunity!

About the Author

Tom Walker is the founder of Walker Capital Preservation Group, Inc. He believes strongly in empowering today’s federal employees through benefits education at retirement workshops and through featured publications. He has compiled many greatly informative resources on his website, and WalkerCPG Facebook page.