In my June 12 column, I discussed the implications of the 2005 Tax Increase Prevention and
Reconciliation Act for Thrift Savings Plan investors. Beginning in 2009, the act repeals the $100,000 income limit that has prevented high-income taxpayers from converting traditional IRAs into Roth IRAs, giving savers the opportunity to pay taxes now, rather than later during retirement.
I concluded that the act offers little, if anything, for an investor rolling a TSP balance into a traditional IRA and then converting this account to a Roth IRA. This week, however, I’ll discuss the act’s significantly more attractive implications for employees covered by the Civil Service Retirement System who have voluntary contribution (VC) accounts.
CSRS employees can make optional payments — voluntary contributions — to the Civil Service Retirement and Disability Fund in addition to the regular CSRS deductions taken from their salaries. The VC accounts behave like traditional IRA accounts. Contributions to the accounts are made with after-tax dollars, and taxes on earnings within the accounts are deferred until withdrawn. VC account balances earn interest at a variable rate that is set each year by the Treasury Department. CSRS employees may contribute up to a total of 10 percent of their cumulative career CSRS basic pay, in increments as small as $25.
A CSRS employee who retires or otherwise separates from service has three options for his or her VC account balance. The balance consists of the contributed amount and any accrued interest.
- You may use the balance to buy a special annuity. This is not the usual CSRS retirement annuity. Under this option, each $100 in your VC account, including earned interest, will provide $7 a year, plus 20 cents for each full year you are over age 55 at the time you retire until your death.
- You can take a lump sum withdrawal. However, remember that the interest earned on this money will be taxable when withdrawn and also subject to IRS early withdrawal penalties if withdrawn before age 59½.
- You can roll the interest — but not the principal — into the TSP or into a traditional IRA. You can also roll the principal into a traditional IRA, but it should be a separate IRA account since you should take care to keep the pretax interest and the post-tax contributions in different accounts.
While all VC account holders currently have the option of moving their money into tax-deferred traditional IRA accounts, the new law will allow more participants to subsequently move their money from taxdeferred IRAs to tax-free Roth IRA accounts. This will be of particular interest to CSRS employees who either have accumulated large VC contribution balances or would like to make large VC deposits before retirement. Employees can move money through a VC account and into a Roth IRA, via conversion from a traditional IRA. This is a way to circumvent the IRA contribution limits and effectively raise the limit to 10 percent of your career basic pay.
For example, a CSRS employee who has earned $2 million over his or her career could contribute up to $200,000 to a VC account before retiring and then roll that amount into a traditional IRA account after retiring. The employee may then elect to convert the traditional IRA into a Roth IRA, regardless of income, once the new law takes effect in 2009. In this example, the participant is able to make a significant contribution using after-tax dollars of $200,000 to either a traditional or a Roth IRA.
By moving taxable savings through the VC account and into a Roth IRA via conversion from a traditional IRA, CSRS employees can avoid future tax on earnings and growth that would otherwise accrue. When the factors of large sums of money, long periods of time or significant returns are involved, the benefit of the conversion can be enormous. In the example above, if the account doubles over 10 years at an average rate of about 7 percent per year, the tax savings from the VC-to-Roth IRA maneuver could easily amount to $40,000 or more.
The difference between the TSP-to-Roth IRA option and the VC-to-Roth IRA option is a big one. The money contributed to the VC account has already been taxed, while the TSP money hasn’t been taxed. The contributed balance in a TSP account has an accrued tax liability against it. The taxes can be paid now, if the money is withdrawn now, or later. Either way, the taxes must be paid. The cost of the Roth IRA conversion is the obligation to pay the taxes now, rather than later.
Your VC contributions have no tax liability against them. There is no cost to moving the money into an IRA, only the benefit of never having to pay taxes on the future growth of the account.
For a CSRS employee in the right circumstances, the new tax law offers a tempting opportunity to save big on taxes. However, there are other important factors that must be considered before taking this course, such as the restrictions on withdrawals from a Roth IRA and your expectations about future tax rates. Make sure you do your homework before proceeding with any account conversion.
Written by Mike Miles
For the Federal Times
Publication June 26, 2006