Tax Diversification in Your TSP

These are some tips for how federal employees can begin investing in the Roth TSP.

Both the traditional Thrift Savings Plan (TSP) and the Roth TSP contributions offer valuable tax savings. The one that is best for you will depend on your current tax rate and what you think your tax rate will be when you retire.

It’s impossible to know for certain what your tax rate will be at retirement. Choosing between a traditional and Roth TSP as the optimal choice is a bit of a gamble. Therefore, it is a good idea to have contributions in both.

Nobody knows what will happen in the economy during your retirement. If you think your tax rate will be much lower when you retire, then a traditional TSP may offer the most savings.

On the other hand, if you think your tax rate will be higher when you retire or that the growth of welfare spending is unsustainable and that income tax rates will be higher for everyone when you retire, you may prefer paying your taxes upfront and investing in the Roth TSP.

Some financial advisers suggest clients hedge their bets by splitting their money between traditional and Roth TSP accounts. But what is the best way to divide your contributions?

If you have only been making traditional TSP contributions and would like to achieve tax diversification through a Roth TSP, here are some ideas to consider.

You do not have to start the journey with a predetermined blend of traditional and Roth contributions for retirement, but you have to begin somewhere.

Here are some ideas on how to start from a zero Roth TSP balance.

Where are you in your career?

You may want to consider a blend tilted more heavily toward the Roth TSP if you are a new employee. Being in a low-income tax bracket, especially in your first year, means the tax deduction you will be missing for the traditional TSP contribution might be a sacrifice your future self will be thankful for after several decades of tax-deferred growth. Sacrifice a little for a nice future tax-free source of income.

Do you have significant deductions?

Do you have a spouse who is not working, children, a mortgage, and other deductions?

Examine your tax return from last year and think about how much of your traditional TSP contributions could be replaced by a Roth contribution. If you have a tax preparer, ask her or him what might be a good starting percentage of your TSP contributions to be directed toward the Roth option.

Are you approaching age 50?

Continue to make your traditional TSP contributions of up to $22,500 in 2023 ($23,000 in 2024). The year you turn 50 means you can put another $7,500 in your TSP savings during 2024 because of the catch-up limit.  

Emotionally attached to the traditional TSP?

Fear not. All matching contributions from the federal government and the 1% agency contribution will go to your traditional TSP account, not your Roth – even if you contribute solely to your Roth account. In other words, a Roth TSP cannot receive matching funds in your Roth bucket and your matching dollars and agency contribution will go into your traditional TSP account. 

Thinking of delaying your Roth contribution?

To be a “qualified” distribution, the Roth TSP distribution must be paid to the owner after age 59 ½. In addition, a 5-year waiting period must also be satisfied. This 5-year period starts with an individual’s first contribution. So, remember your first Roth TSP contribution starts a 5-year countdown.

Thinking of working in post-federal retirement?

Your new job may not have a Roth 401k option. Your new employment income combined with your federal retirement may find a Roth IRA denied to you because of phaseouts.

The Roth IRA direct contribution limit phaseout will increase from $138,000-$153,000 in 2023 for singles to $146,000-$161,000 in 2024 and from $218,000-$228,000 for 2023 for those married filing jointly to $230,000-$240,000 in 2024. So, your last few years as a federal employee might be a good time to sock away those Roth TSP contributions if a high-paying second career is on the horizon.

What about the Roth TSP subject to Required Minimum Distributions (RMDs)?

Roth TSP balances starting in 2024 will no longer be subject to RMDs before a participant’s death because of Secure Act 2.0. Your TSP RMD calculation will include only your traditional balance, and only distributions from your traditional TSP will count toward satisfying the RMD amount.

About the Author

Francis Xavier (FX) Bergmeister retired from the USMC and the F.B.I. Consider following him on LinkedIn as he shares articles from others about retirement and other financial topics. He also provides retirement seminars thru Federal Career Experts.