Is it better to direct your retirement savings into the Thrift Savings Plan or into a Roth IRA?
Central to the TSP versus Roth IRA debate is: Would you rather pay taxes today or tomorrow? Under TSP, you pay taxes tomorrow: You invest pretax dollars today, and taxes are incurred when you withdraw funds from your account. With a Roth IRA, you pay taxes today: You invest after-tax dollars to a tax-free account.
In my opinion, the interests of most federal workers will be best served by contributing the maximum allowed to the TSP each year before making contributions to traditional or Roth IRA accounts. The TSP offers its participants a retirement investment environment — cost, diversification, simplicity — that should serve as the benchmark for retirement investment accounts. Before you decide to contribute to another retirement account, you should consider how it compares with an investment in the TSP.
In the case of a Roth IRA investment, it will be difficult or impossible to produce similar risk and return characteristics in a mutual fund, brokerage or other individual account. In these personal accounts, you have two basic options for managing your investments: You either do it yourself or you have someone else do it for you. Both options produce higher ongoing costs, greater risk or both, compared with TSP. Even using a portfolio of index funds in a discount brokerage or mutual fund account — the best widely available alternative to the TSP — will subject the portfolio to higher costs and correspondingly lower expected investment returns.
But what about the Roth IRA’s tax advantage, you ask. The Roth IRA offers an opportunity to pay taxes today that you could elect to pay later by investing in the TSP.
The potential tax advantage of a Roth IRA — tax-free growth — depends on what happens between the time you make the contribution and the time you withdraw that contribution. Broadly speaking, if your tax rate rises, you win with a Roth IRA. If your tax rate falls, you lose with a Roth IRA. Tax-deferred retirement accounts like the TSP are attractive because many participants assume their tax rates when they withdraw their money in retirement will be lower than when they are working and making contributions.
But, even if your tax rate does rise, a Roth IRA with risk and expected return characteristics equal to those available in the TSP will carry a handicap in the form of higher costs. These costs will tend to depress investment returns over the life of the investment, compared with a similar investment in the TSP. If your tax rates are the same at both ends, your TSP account is likely to come out ahead.
For example, suppose you invest $10,000, before taxes, in your TSP account in a way that is expected to produce 10 percent per year, before expenses, or 9.95 percent after subtracting 0.05 percent for the TSP’s annual expense assessment. Over 30 years, your investment will grow to about $172,100. Withdraw the balance and pay 30 percent in taxes, and you’ll have about $120,500 left.
If, instead, you took the same $10,000 of earned income and paid $3,000, or 30 percent, in taxes, you’d have $7,000 left to invest in a Roth IRA. Let’s say this account carries with it investment expenses totaling 1 percent per year. Instead of earning a 9.95 percent return, as in the TSP example, your investments will grow by only 9 percent per year — 10 percent gross market return minus 1 percent for expenses. This lower net rate of return produces a tax-free value of $92,900 after 30 years.
Compared with the TSP investment’s $120,500, that’s a nearly 23 percent decrease in expected after-tax value due solely to increased investment expenses. In this example, the tax rate at withdrawal would not only have to rise, but would have to rise from 30 percent to over 46 percent before the Roth IRA investment would come out ahead.
Of course, expenses vary from investment to investment, and there may be other factors to consider in your analysis, but the principle applies in every case. And, 1 percent expenses in a mutual fund or other managed account are not unusual.
A common misperception is that it’s inherently better to pay taxes on the smaller of two amounts. That is, it’s better to pay taxes on $10,000 today than to pay taxes on $172,100 tomorrow. If other factors are equal, there’s no difference. As the example above illustrates, if investment expenses or tax rates behave in certain ways, it may be better to pay taxes on the higher amount.
As a federal employee, the TSP should be your primary retirement savings and investing vehicle, unless a thorough and competent — meaning conducted with only your interests in mind — analysis proves otherwise.
Written by Mike Miles
For the Federal Times
Publication March 12, 2007