The Thrift Savings Plan (TSP) is a great tool for federal employees to save for retirement. Saving, and even maxing out your contributions to TSP is normally thought of as a good thing. Yes, maxing out your TSP can be very beneficial, but may not be the best thing for your financial future.
To begin, let me start by saying that saving money is one of the hardest factors to actually do when it comes to retirement planning. A planner can make some tweaks as far as investment allocation, investment location, tax efficiency, etc. but saving money is one thing that a planner can’t do for you. It takes discipline to be able to save money, and especially to max out the contributions to your TSP.
For disciplined investors that are saving money, I have a single question: Is your TSP the best place to save that money? This is really an asset location question that comes down to taxation and access to your money.
In order to expound upon this, I would like to share a situation I encountered recently
John was a retired law enforcement officer (federal LEO). He had two primary concerns that he wanted to address. One was taking money from TSP for a down payment on a second home and the second was paying for his kids’ college with TSP funds.
By most measures John had done a good job of saving in his TSP with total savings of over $650,000. He was receiving a FERS annuity and supplement that totaled $65,000 and was working a new job that had income of over $120,000. At the young age of 50 John was in pretty good shape financially, but this is where the tax issues came in.
What’s the problem with John’s situation?
He was at the top of the 24% tax bracket and any additional income would be taxed at a 32% rate. Once he retires his income will be lower, but right now it’s high. To get a net distribution of $30,000 for a down payment on a house he would have to take a gross distribution of over $44,000. The same goes for college, if he pays for college costs out of his TSP, he will pay a substantial amount of taxes while he is in a high tax bracket.
What could he have done differently?
If John would have paid more attention to asset location when he was saving money, he would be able to accomplish his current goals more efficiently. Access to your money is a great thing, and even greater is access to your money income tax free.
The TSP is possibly the most inefficient account to use for a down payment and to pay for college. Savings in an individual account or a Roth IRA would be much better for the down payment as well as paying for college. A 529 plan would also work well to pay for college.
Below is a list of a few types of investment accounts and how they are taxed.
IRAs, TSP, 401k – These are all tax deferred accounts and all distributions are subject to income tax.
Roth IRAs, Roth TSP, Roth 401k – Taxes are paid before contributions are made to these accounts, therefore all distributions are income tax free. Please not that an account must be open for five years or longer before distributions on earnings are income tax free. Also, any contributions can be withdrawn at anytime without penalty from a Roth IRA.
Individual or taxable account – This is basically a regular account that can be invested in savings, stocks, bonds, mutual funds, or really just about anything. If assets are held for twelve months or longer, then they qualify as long term capital gains which have favorable tax treatment. Any income from bonds or savings accounts is taxed as ordinary income. Tax loss harvesting and charitable giving can help make these accounts very tax efficient. More details can be found in this article.
529 – This is an education fund that allows you to invest money for education and withdraw funds income tax free as long as they are used for education. Information on education accounts can be found here.
Allocating some funds to various accounts versus putting all of your savings in TSP, or any single account, is what we call tax diversification. If John had access to funds in a Roth IRA, he could have accessed them tax free. If he had an individual account, there is a good chance that he could withdraw funds from that account and pay little to no taxes on the distribution. If he had funds in a 529 plan, he could likely withdraw funds to pay for college income tax free.
Lesson – Invest with the end in mind! Saving money is the hard part, but once you are saving please take the time to make sure you are saving in the right place.
Tax diversification is one thing we assist our clients with. If you are unsure which investment accounts you should be using and would like to see how we can help, you are welcome to schedule an introductory call with Brad.
Brad Bobb, CFP® is the owner of Bobb Financial Inc, and an expert in retirement planning for federal employees.