On Jan. 1, private-sector employers will have a new option to offer employees who contribute to 401(k) retirement savings plans, similar to the government’s Thrift Savings Plan. The new option — the Roth 401(k) — allows participants to make after-tax contributions that, along with earnings, grow tax-free. Currently, 401(k) contributions, like TSP contributions, are pretax, meaning the contributions and earnings are not taxed until withdrawn.
The new element is similar to a Roth IRA, which also lets savers invest after-tax money that grows tax-free.
I have received a steady stream of inquiries about the possibility of TSP adding a similar Roth option. Although there is no indication TSP will offer such an option, it is worth considering how valuable a “Roth TSP” might be to you. To help you, I’ll describe some key differences in taxable, tax-deferred and tax-free savings accounts.
Consider what happens to $10 if you are subject to a 30 percent tax rate:
- If you invest after tax in a taxable account, such as a regular savings account, your initial investment will be $7 after taxes. If the account triples over time, you’ll have $16.80 to spend. That’s your original $7 plus $14 in gain, less $4.20 in taxes on the earnings.
- If you invest pretax dollars in a tax-deferred account, say, in the TSP or a current 401(k), your initial investment will be $10. At the same level of return, the investment will produce $30, less $9 in taxes on previously untaxed contributions and earnings. You’ll have $21 to spend. That’s a 25 percent increase in spendable savings that is produced purely from the tax-deferral benefit of the TSP.
- If you invest after tax to a tax-free account, like a Roth IRA or Roth 401(k), your initial investment will be $7 after taxes. After it triples, you’ll have $21 to spend, just like you would in a traditional IRA or TSP account. Again, this is a big advantage over taxable savings, but no advantage over an investment in TSP.
But, there is a potential advantage to a tax-free account over a tax-deferred account.
If tax rates are higher when you withdraw the money than they were when you contributed it, the tax-free account will produce additional returns equal to the value of the additional taxes not applied to the growth in the account. In this respect, the tax-free account is a hedge against rising tax rates, while the tax-deferred account will perform better if your future tax rate falls.
The value of this benefit clearly depends upon the course of future events, which are impossible to reliably predict. Under our current tax rate scheme, it is possible for a middle-income household to have its taxable income cut in half and still be in the same tax bracket.
Unless your income is near the border between brackets, relatively small decreases in your taxable income in retirement will not cut your tax rate.
Federal employees eligible for full retirement benefits, particularly under the Federal Employees Retirement System, should be cautious about assuming they will be subject to substantially lower tax rates in retirement, particularly if retirement is many years away.
Since the contribution limits are generally the same for Roth and traditional IRAs and 401(k)s, the “real” contribution rate for the Roth IRA — in after-tax dollars — is higher. This is because the value of $10, after taxes, is greater than the value of $10 before taxes. But, to capitalize on this difference, you must be able to afford the additional savings.
Contributing $15,000 to the TSP will consume $15,000 of earned income. In a 30 percent tax bracket, contributing $15,000 after tax to a Roth 401(k) account will consume more than $21,000 of earned income.
If you are planning to make the maximum pretax contribution to your TSP account in 2006, which will be$15,000 if your are under age 50, or $20,000 if you are 50 or older, and if you are ineligible to contribute any more money to an IRA but would like to, then a Roth 401(k) account, or its theoretical TSP equivalent, would allow you to contribute more to tax-advantaged savings.
So, how valuable would a tax-free TSP account, with provisions similar to that of a Roth 401(k), be to you?
It might be valuable if it would enable you to direct savings from a taxable account into a tax-free account — that is, if you’re currently making the maximum contribution allowable to tax-deferred or tax-free accounts and you’d like to contribute more.
If you’re not in this position, it’s not likely that the addition of a tax-free TSP option will have a significant impact on your retirement plans. Of course, you’ll have to make the final analysis if and when the terms of such an account become available.
Written by Mike Miles
For the Federal Times
Publication September 5, 2005