For most federal employees, the Thrift Savings Plan should be the foundation of their voluntary retirement savings strategy.

The TSP’s combination of tax advantages, relatively high investment limits, low costs, diversified investment choices, creditor protection and special withdrawal provisions makes it hard to beat as the first choice for retirement savings deposits. In addition, employees covered by the Federal Employees Retirement System receive employer matching contributions that can’t be matched by any individual retirement savings vehicle.

The TSP’s pretax salary deferral limits are, for most full-time employees, significantly higher than those offered by traditional individual retirement accounts (IRA), the only other option that accepts pretax contributions.

As an investment vehicle, the TSP’s low costs and efficient diversification mean that the expected rate of return for each of its funds will be higher than for most similar investments available through other sources. For example, the C Fund, a large-cap domestic stock index fund with annual expenses of 0.10 percent, will have a higher expected annual rate of return than either the Vanguard 500 Index Fund, with expenses of 0.18 percent, or a managed large-cap stock mutual fund, with average expenses of over 1.00 percent per year. In addition, the TSP offers a variety of investment choices sufficient to maintain a diversified asset allocation strategy adequate to meet the needs of virtually any long-term investor.

Unlike a traditional IRA, the TSP offers a special withdrawal allowance for employees who separate from service during or after the year they reach age 55. These employees are permitted to begin taking distributions from their accounts without penalty before age 59½, the minimum penalty-free withdrawal age for the IRA.

If you can contribute more toward retirement than allowed by the TSP limits, I suggest you consider the following alternatives in the order they’re presented:

  • Traditional or Roth IRA. The choice between a traditional IRA and a Roth IRA, if you are eligible for both, can be difficult. In general, I prefer a tax deduction now rather than later and tend to favor the traditional IRA for this reason. While the traditional IRA allows pretax contributions, the Roth IRA is built with after-tax contributions. But you can’t go wrong by maximizing your contributions to either one.
  • Voluntary contributions. Employees covered by the Civil Service Retirement System may make voluntary contributions to their CSRS accounts using after-tax dollars. These deposits are limited to 10 percent of your career basic pay and will earn market interest rates, tax-deferred. At retirement, you may either use the accumulated funds to buy an annuity or you may withdraw or roll your balance over to an IRA. One way to make voluntary contributions is to make ongoing contributions over a period of years. A potential disadvantage of this strategy is that it locks you into an interest-bearing investment. This is fine if you would have invested this money at interest in any event. But if you have a long way to go before reaching retirement and are a  disciplined saver, you may want to consider investing the money in taxable private accounts — I prefer discount brokerage accounts using low-cost index funds — and then making your voluntary contributions all at once just before retirement. Under current law, this strategy allows you to then roll the balance into a Roth IRA, effectively bypassing the IRA contribution limits.
  • Deferred annuity. Deferred annuities are offered by insurance companies and are designed primarily for long-term investing. Unlike immediate annuities, which convert your capital into a guaranteed stream of income, deferred annuities are savings accounts that allow you to retain control of your investment. Technically, deferred annuities are considered life insurance products, although the insurance component is often minimized in favor of investment characteristics.

Deferred annuities offer investors tax deferral similar to that of traditional IRAs. In fact they work just like traditional IRAs except that all amounts are contributed after tax, there is no limit on the amount that can be invested, and there is no mandate that amounts be withdrawn before your death. So, they can be thought of as “unlimited” traditional IRAs.

The cost for these benefits can be high, however. These products are often sold by insurance agents who earn a commission — a commission that is charged to the investor. The ongoing costs of providing the insurance guarantees and administering the account can also be relatively high, eating into the investment performance and offsetting the advantages they provide. There may also be limitations on the investment choices offered and penalties for early withdrawal. All earnings are considered ordinary income — not gains or dividend income — when taxed.

If you consider a deferred annuity, I recommend that you avoid charges and penalties by choosing a noload variable annuity with only the most basic death benefit guarantee. Favor contracts with a wide variety of low-cost investment choices. These contracts can be complex, and I suggest you seek independent expert advice.

Written by Mike Miles
For the Federal Times
Publication January 31, 2005