Military members are accustomed to significant challenges. Combat tours, deployments, and frequent transfers are just a few of the difficulties they face on a frequent basis. Perhaps because of this stress, many military members experience significant struggle when it comes to getting ahead financially.
A recent FINRA study reveals that despite a regular paycheck, military members are struggling with significant debt. 82% of military families carry an average credit card balance of $10,000 – and it gets worse. One in four service members reports overdrawing their checking account in the last year, one in five has used a payday loan or auto title loan in the past five years, and only one in two has an emergency fund.
What this means is that most military members shouldn’t even consider serious investing until they get out of debt and develop a savings cushion. But for those members who have paid off their non-mortgage debt and have an adequate emergency fund, it is time to save for retirement.
If you’re in the military, the pay may not make you rich, but you are afforded excellent opportunities to save and invest that are not available to civilians. By understanding how to take advantage of such opportunities, you can secure your future and build an enviable nest egg.
The military pension system is the single most important financial resource available to service members who choose to remain in service for 20 years or more. It provides an immediate annual income upon retirement which corresponds to 50% of the member’s base salary at 20 years, and is further increased by 2.5% for every additional year of service.
Plus, the retiree will receive an annual cost of living increase linked to the Consumer Price Index (CPI). Along with an impressive pension, military retirees are provided affordable lifetime medical coverage and access to other benefits, such as base access and exchange shopping privileges.
In spite of these benefits, a military pension is frequently not sufficient to cover all your annual expenses.
Thrift Savings Plan
The U.S. government’s Thrift Savings Plan (TSP) is a vastly underutilized investment resource. Current statistics indicate that only 37% of military members choose to participate. If you are a military member looking to save for retirement, the TSP is a convenient, low-cost, and tax-smart way to do it.
Like 401k contributions, money invested in a TSP is not subject to federal income tax, which effectively increases the amount you’re able to contribute. For example, if a service member who pays 25% in taxes contributes $10,000 to their TSP, they will only reduce their take home pay by $7,500. This can be a huge benefit, as the time value of money can result in substantial monetary gains. That said, once funds are withdrawn during retirement, members must pay income tax on the entire withdrawal.
However, members who contribute tax exempt combat pay can withdraw these tax-free contributions in retirement without paying taxes on the withdrawals. This is an impressive benefit not readily available elsewhere.
Other benefits to investing with the TSP are the rock-bottom expenses associated with the program. The expense ratio for the TSP is about as low as you will find anywhere, amounting to approximately 0.015%. With an expense ratio this low, your contributions can compound at a faster rate than in a traditional mutual fund, which typically carries a 1.5% expense ratio.
Low expense ratios help members keep more of their hard-earned dollars invested, rather than paying that money to expensive mutual fund managers. This is especially valuable since the TSP also offers target date funds with exceptionally well designed glide paths that ramp down risk as you near retirement. Ordinarily, these types of funds carry even higher expense ratios when purchased outside a TSP.
The maximum allowable contribution to the Thrift Savings Plan is $16,500 if you are under the age of 50, or $22,000 if you are over the age of 50. This scaled contribution limit enables employees rapidly nearing retirement age to stash more cash during the remainder of their working years.
Unfortunately, unlike their civilian counterparts, military members are not currently eligible for TSP matching funds or agency automatic contributions due to the generous defined benefit retirement system (the pension) that is currently in place.
The TSP offers different investment options, depending on your risk tolerance and the number of years until you retire. Participants can invest in one or multiple funds to further diversify across a range of investments.
- G Fund. The default investment fund for the TSP, the G Fund is comprised of government securities that offer low volatility and conservative returns over time. If you don’t choose one of the other funds listed below, all contributions to your TSP will default into the G Fund.
- F, C, S, I Funds. The F, C, S, and I Funds are index funds that invest in bonds, large cap stocks, small cap stocks, and international companies, respectively. They strive to match the performance of different open market index funds and are managed by BlackRock Mutual Funds.
- L Fund. The L Fund (the “L” stands for “life cycle”) is a recent addition and allows investors to choose a date closest to their expected retirement date. The fund allocates assets according to the length of time you have until retirement and adjusts into more conservative investments as retirement nears.
Members can withdraw contributions and earnings without penalty from their TSP after age 59 1/2, and all withdrawals are taxed as ordinary income. However, withdrawals from a member’s TSP account prior to age 59 1/2 are subject to a 10% penalty in addition to income taxes.
If a member decides they do not need retirement income until later, withdrawals can be deferred until age 70 1/2. At this point, required minimum distributions must be made annually in order to draw down the account balance. If a member does not make withdrawals at this time, they will face stiff penalties.
If you need money from your TSP while still employed by the military, you can take out a loan which needs to be repaid to your TSP account within 1 to 15 years, depending on the type of loan. Two loan types are available: a general purpose loan and a residential loan. The former has a repayment period of one to five years and may be used for any purpose, while the latter has a repayment period of up to 15 years and can only be used to purchase or construct a primary residence. Moreover, a residential loan requires documentation to prove the intended use.
Keep in mind that when you take out a loan, you give up any earnings the loaned amount would have otherwise accrued, and you will be double-taxed when you pay the interest on your loan from after-tax funds. This is because these funds will be taxed again when you withdraw them during retirement.
Roth IRAs offer several benefits to long-term investors seeking tax-free growth. You may wish to supplement your TSP with a Roth account, or invest in one exclusively, depending on your situation and goals.
Unlike the TSP, the tax benefits to investing in a Roth are not immediate. The TSP reduces your taxable income, which will reduce your total tax burden on April 15th. But as attractive as reducing your taxable income may seem, tax-free growth can be even more beneficial, depending on what your income tax bracket is now and where you think it might be in the future. The Roth IRA allows you to invest after-tax funds on which the growth will never be taxed – even upon withdrawal.
Federal law allows for a contribution of $5,000 a year to a Roth IRA ($6,000 if you are at least 50 years old) as long as your income is less than $105,000 a year if you are single, or $166,000 or if you are married. It is important to understand that you must have earned income to contribute to a Roth IRA, although one working spouse can contribute to a non-working spouse’s Roth IRA, enabling a total married contribution of up to $10,000 a year ($12,000 for a married couple age 50 or older). See the maximum 401k and Roth IRA contribution limits for more information.
Although Roth IRAs do not offer an instant tax deduction, they do provide one important benefit: absolutely tax-free growth and tax-free distributions. Tax-free distributions of earnings can be made after you turn 59 1/2 and, unlike the TSP, Roth IRA rules do not require mandatory distributions after age 70 1/2.
Any earnings withdrawn prior to age 59 1/2 will be taxed and penalized 10% by the IRS. One important thing to note, however, is that penalties do not apply when contributions are withdrawn because these monies have already been taxed. Fortunately, if you make any withdrawals from your Roth prior to age 59 1/2, they will be considered withdrawals of contributions until you’ve withdrawn everything you put into the account. Only after that point – once you withdraw earnings – will you be taxed and penalized.
The great thing about a Roth IRA is that you can open one through almost any financial institution that sells securities and does investments. In other words, your investment options are virtually endless. Some choose to invest in mutual funds, while others actively trade individual securities within their Roth IRA. Because you have a wide array of investment options, you can seek ones that fit your age, risk tolerance, and style of investing while also allowing you to control costs.
Military members who like the idea of decreasing taxable income, but seek more investment options than the TSP offers, can open a traditional IRA instead of or in addition to a Thrift Savings Plan. Like the Roth IRA, traditional IRAs are available through a host of financial institutions and offer an almost unlimited number of investment options.
Like the TSP, contributions to a traditional IRA are tax deferred and reduce a member’s annual tax burden. This, in turn, can effectively increase the amount you’re able to contribute. For example, a $5,000 contribution could only cost you $3,750 in income if you’d otherwise pay 25% in taxes on that money.
You can contribute up to $5,000 if you are under the age of 50, or $6,000 if you are age 50 or older. You or your spouse must be working to contribute monies, and no matter your income, you can open and contribute to a traditional IRA. However, to get the full tax deduction, you must earn less than $56,000 per year if you’re single, or less than $90,000 per year if you’re married.
A word of caution if you consider investing in both the Roth and a traditional IRA: Federal law prohibits contributing more than the limits discussed above to one or to multiple IRAs. This means you can’t contribute more than a combined $5,000 per year to both a Roth and a traditional IRA (unless you are at least 50 years old, in which case you could contribute $6,000).
Unlike the Roth, you cannot withdraw any monies prior to age 59 1/2 without being assessed a 10% early withdrawal penalty as well as regular income tax on the withdrawal. Contributions as well as earnings that are withdrawn early will be taxed and penalized.
This makes the Roth IRA the wise option if you may need a portion of or all of your contributions prior to retirement. Furthermore, you must begin making required minimum distributions from a traditional IRA when you turn 70 1/2 or face stiff penalties.
Like the Roth IRA, the traditional IRA can be opened at most any financial institution that manages investments. This means your options for investing are as varied as your imagination. You could, for example, invest in target date funds, mutual funds, ETFs, equities, bonds, or options. The investment world is your oyster, and you can choose the type of investment strategy and long-term methods that suit your personality and objectives best.
The Federal Thrift Savings Plan should be one of the first stops for military members who seek to efficiently grow retirement assets. This is because the TSP’s great low-cost fee structure allows you to save a fortune in management fees and expenses when compared to the majority of investments available to civilians. But members who want to further diversify their investment portfolio would be wise to consider opening a Roth or traditional IRA. You can invest individually or in a combination of all these vehicles.
The choice is yours and will be largely determined by your tax bracket, your thoughts on future taxes, how much freedom you want to choose investments, and how much you can contribute. These retirement accounts can serve as a great source of wealth and security in your later years, and an excellent supplement to your military pension.