Last week in “Tips to Avoid 9 Costly Mistakes: Part 1”, I covered 5 costly mistakes to avoid.
This article (Part 2 of 2) unveils 4 additional TSP mistakes to avoid. Some of these mistakes are simple to explain, while others require more lengthy explanations.
Mistake #6: Not Contributing to the Roth TSP
Let’s kick this off by visiting a favorite cartoon series: The Road Runner. In this episode, Wile E. Coyote was trying to build a bomb to kill the Road Runner. He was building this bomb in a shed on a railroad track. When he heard a train whistle, he looked out the window and saw a freight train bearing down on him. He quickly made a calculated decision and pulled down the shade.
Like Wile E. Coyote, as Americans, we have a freight train approaching us in the form of taxes.
Many believe, as I do, that in order to reduce our national debt (currently just under 20 trillion) and help fund over 100 trillion dollars in unfunded promises, including: Medicare, Social Security, Federal Employee and Veteran’s Benefits, we can expect significant tax increases in the not to distant future.
Now, while there is nothing we as individual can do to fix these problems, we can be proactive in applying tax planning to help protect our retirement from unexpected taxes. Or, we could simply ignore the problem, and pull down the shade like Wile E. Coyote.
One of the easiest ways to employ proactive tax planning is to take advantage of the Roth TSP. Federal employees, who are eligible to contribute to the Thrift Savings Plan (TSP), are also eligible to contribute to the Roth TSP. A Roth investment allows you to pay tax on the seed (the smaller, starting investment) and reap the bounties of the harvest (the investment plus earnings) tax-free. Do you want to pay taxes on the seed, or the harvest?
Additional considerations to consider when choosing Roth TSP:
- You’re paying the tax now in today’s known tax rate environment.
- Most people have fewer deductions in retirement. Many may lose their two biggest deductions: their kids and mortgage interest.
- Today’s retiree want to maintain their current lifestyle, which they have worked and sacrificed for. This can be difficult when you consider that most of your retirement income sources are taxable. Federal pension (approximately 10%), up to 85% of Social Security benefits, withdrawals from traditional TSP and other retirement accounts, etc.
Mistake #7: Transferring TSP to an IRA Prior to Age 59½
If you retire at age 55 or later and need to access TSP, there will not be a 10% early withdrawal penalty. However, withdrawals taken from an IRA prior to age 59½ will be subject to this 10% penalty.
If you want to transfer TSP to an IRA, make sure you leave enough in TSP to cover any withdrawals you may need prior to age 59½.
Mistake #8: Not Understanding a Beneficiary Participant Account (BPA)
First, the ground rules:
- A BPA account is only available to a surviving spouse.
- No other beneficiary may leave funds in TSP
- BPA owner may take a partial withdrawal (even if their deceased spouse had already taken a partial withdrawal), and then a full withdrawal, as follows:
- A single payment
- A series of monthly payment
- A life annuity
- A combination of all three
Many federal employees suggest to their spouse that they leave the funds in TSP if they predecease the non-federal annuitant. They can continue to reap the benefits of TSP: low fees, monthly withdrawals, while at the same time keeping it simple for the surviving spouse that may be uncomfortable investing, by utilizing the L-Income Fund or if completely adverse to risk, the G Fund.
There are some complications that may occur, and it is vital that you and your spouse are both aware of these restrictions:
- At the spouse’s death, the funds cannot remain in TSP. They are paid out directly to the BPA owners’ beneficiaries. Caution: They cannot roll over this inheritance to an Inherited IRA, which they would be able to do if the money was already in an IRA. This means that the funds will be taxed at the beneficiaries’ ordinary tax rate and will be added to their other income, which could result in Uncle Sam getting a nice chunk of this inheritance. Remember, if the surviving spouse had rolled over the TSP into an IRA, any balance left at their death could be rolled over to their designated beneficiaries, via an Inherited IRA, avoiding a significant tax bite.
- Another issue that does not play out favorably for BPA owners is they must use the Single Life Expectancy Table for Required Minimum Distributions (RMDs). This table requires a larger distribution than the Uniform Table, which a TSP owner or IRA owner would use to calculate RMDs. If the surviving spouse had rolled over the TSP into an IRA, they could calculate their RMD using the friendlier Uniform Table.
Mistake #9: Not Understanding Options for TSP Penalty-Free Access Prior to age 55
If you separate service prior to age 55, you can take life-expectancy withdrawals and avoid the 10% early withdrawal penalty. You are locked into this payment for the longer of 5 years or attaining age 59 ½.
Make sure that you don’t fall into this trap: You begin taking life expectancy distributions at age 50 and you are now 55, so you contact TSP and stop the distributions. Five years have gone by and you mistakenly think you have satisfied the 5-year rule, however, it must be the longer of 5 years or attaining age 59 1/2. Because of this mistake you would owe the IRS 10% of the total amount you withdrew from TSP during those 5 years.
- Payment is based on your age, and your TSP account balance.
- Payment is made in all 12 months, and is recalculated each year, based on your age and your TSP year-end account balance from the previous year.
|Life Expectancy (See all ages IRS Pub. 590)|
See IRS Single Life Expectancy for all ages or go to www.TSP.gov and calculate monthly withdrawals
The Thrift Savings Plan can be a vital source of income in retirement. To maximize the potential of this investment vehicle, it is up to you as an individual participant to make contributions, choose an investment allocation that’s appropriate for your risk tolerance, and to become educated on mistakes to avoid, so as not to threaten your retirement and your opportunity for maximizing wealth.
Securities offered through GF Investment Services, LLC. Member FINRA/SIPC. Investment advisory services offered through Global Financial Private Capital, LLC. This is provided for informational purposes only and is not intended to provide specific tax or legal advice or serve as the basis for any financial decisions. Be sure to speak with qualified professionals before making any decisions about your personal situation.