The U.S. Federal Government’s Thrift Savings Plan (TSP) is a deferred contribution retirement plan for Federal employees. The TSP is administered by the Federal Retirement Thrift Investment Board, an independent government agency, for the benefit of civilian Federal employees as well as active duty and reserve military members.
The TSP offers similar savings and tax benefits to a traditional 401k plan. You can contribute up to $16,500 of pre-tax income if you are under the age of 50, or $22,000 if you are 50 or older. The amount you contribute plus any matching funds deposited by the government accumulate tax-free until you withdraw funds during retirement (defined as age 59 1/2 for tax purposes). At this point, the entire withdrawal is taxed as ordinary income.
However, some employees prefer the Roth model, where contributions are taxed, but withdrawals are tax-free. Fortunately for these investors, a new retirement option is soon becoming available to Federal employees called the Roth TSP.
The Roth 401k
Over the past few years, more and more employer-sponsored retirement plans have begun to offer a Roth 401k option as an alternative to the traditional tax-deferred 401k plan. Unlike the traditional 401k, the Roth alternative allows investors to contribute after-tax income to the fund. As a result, all withdrawals upon retirement are completely tax free.
The advent of the Roth 401k has left many investors wondering whether they should ditch their traditional 401k in favor of the Roth option or, at the very least, move some of their funds over to a Roth 401k.
Thrift Savings Plan to Offer a Roth Option in 2012
As a result of the Thrift Savings Plan Enhancement Act of 2009, a Roth TSP option will become available in the second quarter of 2012, and TSP investors will soon be presented with a similar choice as the Roth 401k.
Should they contribute funds to a Roth TSP or a traditional tax-deferred TSP? Careful consideration of the following factors will help TSP investors decide which type of plan is best for them.
Advantages of a Roth TSP
Over a Traditional TSP
- The key benefit of the Roth TSP option is that it allows investors to make tax-free withdrawals upon retirement. This is ideal if you’re concerned about future tax rates, think you’ll be in a higher income tax bracket during retirement, or if you’re young and have many years for the gains in your retirement portfolio to compound.
- Further, there is greater flexibility regarding the withdrawal of Roth contributions than traditional TSP contributions. For example, you can withdraw Roth contributions at any time, penalty and tax-free.
Over a Roth IRA
If a Roth IRA has similar tax treatment, why shouldn’t investors simply choose this over the Roth TSP?
- First, the Roth TSP allows a maximum annual contribution limit of $16,500, whereas the Roth IRA only allows a maximum annual contribution of $5,000.
- Second, there are no income limits for the Roth TSP, and with the Roth TSP, you are eligible for matching employer contributions based off your own contribution. Employer contributions are essentially “free” money that can only be collected via employer sponsored retirement plans.
- Finally, because TSP investment options boast some of the lowest expense ratios in the industry, a Roth TSP will probably be less expensive than a Roth IRA, which means more money for you at retirement.
Disadvantages of a Roth TSP
There are two key downsides to the Roth TSP as compared to the traditional TSP.
- First, for high-income investors, the traditional TSP may make more sense since it provides them with a significant near-term tax break. For these investors, the short-term tax break may be larger than the benefit they would receive from the tax-free retirement withdrawals offered by the Roth TSP option. Of course, the caveat is that if investors make a significant return on their investments over the course of the Roth TSP, they will pay taxes on that as well.
- Second, employer-funded, matching contributions will not change because of the Roth feature. What this means is that they will still be tax-deferred; ordinary income tax will be due upon their withdrawal and the withdrawal of their associated gains during retirement, even though your contributions and their associated gains will be tax-free. It also means that your dollar contribution to the plan still determines your employer’s contribution.
For example, if you elect to contribute less to the Roth option in order to afford the taxes you must pay on those contributions, your employer’s match will also be less than what you otherwise would have contributed to a traditional TSP. In other words, you’ll have to weigh the tax benefit against any potential loss you might experience from a lower Roth contribution and thereby lower employer match. That said, if you contribute the annual maximum to the Roth TSP, you’ll still receive your employer’s maximum match.
Who Should Participate in the Roth TSP
Whether or not you should participate in the Roth TSP will depend primarily on how you feel about tax-deductibility now vs. tax-free later, and how it will affect you. Roth plans are often ideal for younger investors who have many years for retirement earnings to compound, who are often in a low tax bracket, and who can afford the income tax on contributions now.
The Roth TSP, like the Roth 401k, may also be ideal for investors whose income makes them ineligible to open a Roth IRA, or for investors already contributing to a Roth IRA but who would like to contribute more. For this latter group, it may make sense to redirect Roth IRA contributions to a Roth TSP in order to take advantage of the government’s match. The Roth TSP can also be a good vehicle to diversify tax risk in a primarily tax-deferred retirement portfolio.
The Roth TSP has been long-awaited by Federal employees. Now that it is finally nearing, it is an important option to consider as a way to diversify one’s retirement funds.
What are your thoughts on the Roth Thrift Savings Plan? Do you plan on participating once it’s offered?