Saving more, saving earlier in life and saving before taxes each can produce great rewards. Combining all three is an opportunity that should not be missed.
For many federal employees, nurturing that retirement nest egg is about to get easier. That’s because the limits imposed on Thrift Savings Plan contributions are set to increase, in some cases dramatically, on Jan. 1. The new limits will permit most federal workers to save more and improve their standard of living in retirement.
But this opportunity will only benefit those who take advantage of it early enough to make a difference.
Beginning in January, the limits on TSP contributions will no longer be expressed as percentages of earnings, but rather as dollar maximums. Currently, the TSP contribution limits are 15 percent of pay for those in the Federal Employees Retirement System and 10 percent for those in the Civil Service Retirement System and uniformed services. The new limit will be $15,000 for employees up to age 49. Employees age 50 and older will also be allowed to defer up to an additional $5,000 per year as a catchup contribution. These flat dollar limits will be $1,000 higher than their 2005 levels.
While CSRS-covered employees will see the larger percentage increase in their ability to contribute, FERS participants, as a younger group, stand to benefit the most since their time horizons — the time between their contributions and the point at which they’ll need to withdraw their money — tend to be longer. A dollar today will likely only be worth about a dollar tomorrow, but in 20 years it could easily be worth $8, or more.
To illustrate the significance of the new contribution limits, consider a hypothetical FERS employee, age 35 and earning $50,000 per year. Under the current rules, he could defer, at most, 15 percent, or $7,500 of his pay, pretax, into TSP. Under the new rules, he will be able to defer up to $15,000, or 30 percent of his pay in 2006 — a 100 percent increase. If this employee can double his contributions, he can double his TSP-derived income stream in retirement. Even if he can’t fully capitalize on the higher limits, increasing his contributions by less than the maximum allowance or making the maximum allowable contributions in some years, particularly the earlier ones, can dramatically improve his retirement plan.
To help you appreciate the value of saving early for retirement, you can use the Rule of 72 to make some quick calculations. This rule calculates the amount of time it will take your investment to double in value at a certain rate of return. To make the calculation, divide 72 by the rate of return. If you use an annual rate of return in the calculation, the answer will be the number of years it will take for your money to double in value. So, if your investment returns 10 percent per year, it will double in value every 7.2 years. The difference between investing today and investing tomorrow is the value of doubling the accumulated value
again on the far end. Invest $10,000 today at a 7 percent annual return, and in about 10 years, you’ll have $20,000. In 20 years you’ll have about $40,000. And, in 30 years your investment will have grown to about $80,000. Waiting 10 years to invest will, at the end of 30 years, cost you $40,000.
For CSRS employees, the new limits represent a bonus in addition to their retirement annuity — extra retirement income or an earlier retirement. For FERS employees, it is a significant strengthening of their TSP accounts, one of the three essential legs of their retirement platform.
Taking advantage of the higher limits will mean shifting investment from taxable to tax-deferred status — a move that can pay handsome rewards on its own. If you are subject to a 30 percent marginal tax rate and invest $7 after tax in a taxable account and it triples over time, you’ll have $16.80 to spend. That’s your original $7 plus $14 in gain, less $4.20 in taxes. At the same time, investing $10 pretax, say, in TSP will produce $30, less $9 in taxes, leaving $21 to spend. That’s a 25 percent increase in spendable savings that is produced purely from the tax-deferral benefit of the TSP.
Written by Mike Miles
For the Federal Times
Publication December 12, 2005