The introduction of a Roth (post-tax) option for Thrift Savings Plan (TSP) investors in 2012 was welcome indeed. Previously, federal employees who wanted to put away money for retirement that would not attract taxes upon withdrawal were restricted to the much lower amounts allowed under an IRA, assuming they were within the IRS income limits. Whether “going Roth” is the best choice for you is, of course, a conversation all its own. But let’s say that you do…
Here’s a conundrum: Should the asset allocation for your Roth TSP be any different than if you were saving for retirement “traditionally?” Certainly, during the many accumulation years (decades, in fact) of your working career, the answer is “no.” You will make your decision between stocks and bonds based on your ability to take investment risk, measured both emotionally and quantitatively. Tax treatment really doesn’t enter into the asset allocation conversation at this point.
But when you are close to the decumulation years, things may change. The conventional financial planning wisdom is that all things being equal, one should tap their Roth savings last in retirement, after traditional retirement assets. The growth in Roth assets will never be taxed, so it is prudent to keep this part of your portfolio sheltered from taxation as long as possible.
When You Have All the Time in the World
Let’s start at one end of the time spectrum: infinity. If your goal is to leave a legacy for your heirs, assets in a Roth account (as opposed to a traditional retirement account) are more inheritance-friendly because the taxes have already been paid. Your grateful offspring can inherit your Roth assets without any worry that their distributions from the inherited account will be taxed. What’s more, the distributions from the account will not increase their own taxable income.
In this case, the timeline for investing your Roth assets — that is, the time between now and when someone will use the assets — is perhaps not actually infinity, but it is likely several decades past your own retirement date. (Your heirs have 10 years from your death to liquidate the account.)
So, while your overall risk profile may lead you to a balanced approach between stocks and bonds, the specific assets in the Roth account may have a much longer shelf life and may warrant a different asset allocation, likely more weighted to equities.
When You Need Your Roth Assets Sooner, Not Later
Now let’s visit the other end of the time spectrum: early retirement. This has the potential to turn that conventional wisdom on its head.
You may be considering leaving the federal workforce before the age at which you can collect your full Social Security benefit, possibly even in your fifties. Perhaps your plan is to meet your living expenses during these “downshift years” through a combination of your federal pension, distributions from your TSP, and perhaps income from part-time employment. (After you turn 67, or even 70, you will reduce your TSP distribution in favor of your Social Security benefit.) These TSP distributions may be a regular income stream or an occasional withdrawal to meet lumpy expenses.
This is where a Roth TSP, as opposed to a traditional TSP, could be a good friend. If you supplement your income with Roth distributions, your only taxable income will be your pension (and any part-time employment, should you so choose). During a time in your life when you may be adjusting to life on a smaller income, this difference in cash flow could be rather meaningful to you.
In this scenario, the timeline for when you will use your Roth assets is very different than someone who does not plan to tap their resources during their lifetime. A shorter time horizon demands a different asset allocation.
Is there an action I need to take today?
A rough and ready rubric for those still working and contributing to their TSP is as follows:
- Tax diversification, just like asset diversification, is your friend.
- You won’t be tapping any of your retirement assets anytime soon, so choose your asset allocation based on your risk preferences, not whether you are using Roth, traditional, or both.
When you are within a few years of retirement:
- Closely evaluate the tax treatment of your retirement savings. With greater knowledge of your retirement and legacy plans (and prevailing tax policy), is there a need to change up your contribution between Roth and traditional accounts for your remaining working years? Should you reposition your existing portfolio, converting some traditional assets to Roth? (Presently, Roth conversions within a TSP are not allowed.) For an especially early retiree (pre-55 years old), should you be flexing your attention to non-qualified (i.e., taxable) investing?
- Now consider if your asset allocation matches the timeline for your use of your TSP account. Remember, your Roth and traditional “sides” are invested identically. Specifically, if you have both Roth and traditional TSP assets and there is a significant divergence between when you plan to tap into each, post-retirement you may be a candidate for rolling over at least part of your TSP to an IRA to achieve a different asset allocation between the two types of accounts.
It is never my aim to make investing for retirement seem more complicated than it is. And yet, it is inescapable that introducing the Roth option, while beneficial to many federal employees, nevertheless added an additional layer of shall-we-call-it-nuance? to retirement planning. But the essential —and simple — investment take-home point is unchanged: if you know what you are investing for and when you need to access the investment, your asset allocation decision will follow quite easily.
Lisa Whitley is an Accredited Financial Counselor (AFC®) and Chartered Retirement Planning Counselor (CRPC®). After an 18-year federal career, Lisa became a personal finance coach & planner in 2019. Her firm, MoneyByLisa, is a Registered Investment Advisor domiciled in the District of Columbia.
