The TSP is designed to make up one third of federal employee’s retirement income, but taking money out of it can be a tough decision. One of the most common distribution strategies I have heard is, “I’m going to wait until 72.”
What does “I’m going to wait” mean? When I probe a little more to see exactly what the person means, the answer I usually hear is “I’m going to wait until age 72 when I have to take distributions.”
Why wait till 72? Some answers I have heard are:
- I want to save my TSP
- I don’t need it
To be certain, people in this situation are going to be much better off financially in retirement than the retiree that takes large distributions and runs out of money, but is waiting the best thing to do? Financial planning isn’t only about putting yourself in a good situation, it’s also optimizing the resources you have.
Many times, the reason the people don’t take money out of their TSP is fear. Retirement and the distribution stage are completely different than what most people have grown accustomed to - saving for retirement. Then there is the question of how much of a distribution a retiree can take, which can be challenging as well.
Sometimes, delaying withdrawals from TSP isn’t the best option, and I would like to offer two legitimate reasons why a person shouldn’t delay.
- It’s time to enjoy life and spend some money
- By delaying you are also delaying your tax liability as well as compounding it
It seems odd, but I have encouraged a retiree to spend some of their retirement savings more times than I can count. Retirement can be difficult because you are forced to do a 180 degree turn and start taking distributions instead of saving (which most people have been doing for 30+ years!). There is nothing wrong with developing a responsible retirement plan and periodically withdrawing money from your investments.
If spending isn’t your thing, do you enjoy giving money to kids, grandkids, or charities? Some retirees plan to leave a substantial amount of assets to family members, which is a valid strategy, however, if it’s possible to start gifting assets now, why wait? Gifting for grandkids’ education or even a down payment on a home could be a satisfying way of spending.
Delaying can create future obstacles
Here are a few things that delaying your TSP distributions does:
- Allows your assets time to grow, which increases your tax liability
- Gives you less control in the future
- Gives your beneficiaries less control
These three obstacles are hard to argue with. As a tax deferred investment grows so does the tax liability that someone will eventually have to pay, as well as the RMD that you are forced to take at 72. Your beneficiary’s tax liability and possible RMD grows as well.
What Should I do Differently?
Everyone that invests money should also consider the tax ramifications before making an investment. This is really simple – paying more in taxes means less money that the investor gets to keep. One of the biggest mistakes I believe people make when saving for retirement is not saving with the end in mind. A great example of this are federal employees who are retiring and say they have enough income from their FERS Annuity and Social Security, and all of their savings is in Traditional TSP. They have no need or plans to take distributions from TSP.
If you don’t plan to take distributions, then the TSP probably isn’t the best investment vehicle for you. Here are a few ideas that you could use to ease your future tax burden and RMDs.
- Contribute to Roth IRAs immediately! Individuals over age 50 can contribute $7000 per year. This is the easiest thing to do. If you are over the income limit for contributing to a Roth, then you may be able to do a backdoor Roth IRA.
- Contribute to Roth TSP. Everyone can contribute to Roth TSP regardless of income. The limits in 2020 are $19,500 plus an additional $6,500 for employees age 50 and older.
- ROTH CONVERSION
- ROTH CONVERSION
- ROTH CONVERSION
Did I hear somebody say Roth conversion? Yes, if you have assets in a tax deferred account, like the Thrift Savings Plan or an IRA, conversions are something you should look at annually. The reason is you can make the asset more tax efficient to accomplish your future goals. By moving assets to a Roth IRA, you gain a few advantages:
- No forced distributions
- Income tax free withdrawals
- Passes to heirs income tax free
- Heirs can stretch the assets income tax free
- Reduce your future RMDs from your IRA or TSP
Current taxes are the primary reason it’s beneficial to look at conversions annually versus converting all at once. A $500,000 conversion in one year means $500,000 of taxable income in that year. This could easily push the retiree into the top tax bracket of 37% versus 22%, and could also cause you to pay higher Medicare premiums. Instead of a full conversion, it may be beneficial to convert $22,000 this year because that is the amount left in the 22% tax bracket.
Waiting until age 72 when withdrawals are forced tends to be a common strategy for many federal employees. While it may be common, and the people doing it tend to be responsible with their money, I have found very few instances where it is the optimal strategy. I would like to urge you to look at your goals and see if your savings instruments match up with them. If not, make some changes. If you need help and would like a partner on your retirement journey I’d be happy to schedule a call and see if we can help.
Brad Bobb, CFP® is the owner of Bobb Financial Inc, and an expert in retirement planning for federal employees.