The recent congressional proposal to add a Roth-type account option to the Thrift Savings Plan should raise the interest of TSP participants in the potential value that such an option might bring them. However, I think that there is considerable confusion among TSP participants over the potential advantage of adding this option.
Contributions to TSP now must be made with pretax money, and any earnings or growth that might accrue is sheltered from tax until the money is distributed. The intent is fairly straightforward: Reduce your taxable income now, and pay taxes later. Not a bad deal, in most cases, as long as you don’t violate the rules and trigger an early withdrawal or other penalty.
Adding a Roth-type account option to TSP would allow participants to make contributions using after-tax money – paying tax on contributions now and avoiding all taxes on earning and growth later. The idea of tax-exempt income in retirement is appealing, particularly when it is promoted as “tax-free.” That word “free” always seems to get the heart rate up a little. But determining the value of a “Roth TSP” account, and deciding whether and how much to contribute to it, if it becomes available, is not as easy as some might think – or want you to think – it is.
First, we all need to understand and agree that simply paying tax now does not carry an inherent advantage over paying tax later.
Assume that you contribute $100 of your earned income to your TSP account, before paying any taxes on it, and let it grow by 10 times to $1,000 over time. If you lose 30 percent of it to taxes upon withdrawal, you’ll be left with $70.
Alternately, you could take the same $100 of earned income, pay $30 of it in taxes and then contribute the remaining $70 to a Roth-type account. If you let it grow by 10 times, to $700, and then withdraw it, without tax, you’ll have the same $700 to spend.
As long as the tax burden affecting the contributions and distributions is the same, there is no advantage to be derived simply from tax-free versus tax-deferred status.
But, this isn’t the whole story. There are other factors to consider that affect the outcome – such as your age, your income, your ability to save, your investment time horizon, the duration of your retirement, your other sources of retirement income and your tax rates. Even your goals and priorities can be important factors.
For example, if you intend to leave your account to your heirs and never rely on it for retirement income, there can be a significant advantage to using a Roth account, which will often produce a higher after-tax ending value than the tax-deferred alternative.
But, if you’re more concerned about the amount of after-tax income you will be able to draw during your lifetime, then the relative attractiveness of a Roth TSP account can be difficult to estimate.
If you’re young, say in your 20s, and plan to save and work until you are in your mid-60s, then expect to have to contribute to a Roth TSP at least 80 percent, after taxes, of what you would have contributed, pretax, to a regular TSP account to expect to achieve the same spendable income in retirement.
For older participants, the break-even percentage increases. Add to this the effects of such factors as Social Security taxation rules, minimum distribution requirements and payroll tax rates, and the analysis can become considerably more complicated.
If a Roth-like TSP account becomes a reality, you are sure to see and hear general recommendations either for or against its use. But there is no single valuation or recommendation this will work for all, or even most, TSP participants. At best, your decisions will be based on predictions about a variety of future circumstances and outcomes.
But you should be clear on one thing: What matters more to your retirement income than the decision you make on whether to contribute to the tax-deferred TSP, a Roth TSP, or both, is that you contribute as much as you can to at least one of them. In either form, TSP’s low costs and efficient design make it the best place to save for retirement you’re likely to find anywhere.
Written by Mike Miles
For the Federal Times
Publication June 2, 2008