Employees covered by the Civil Service Retirement System have the option of contributing money to a voluntary contributions account to increase the size of their annuities.
These accounts are similar to Thrift Savings Plan accounts in two ways: Earnings that accrue are not taxed until they are withdrawn; and, in certain instances, tax on earnings distributions can be delayed even further by rolling the balance over to an IRA.
Unlike TSP, however, a voluntary contributions account will accept only contributions made with after-tax dollars. This means the account always has a “basis” for tax purposes – that is, an amount of contributed principal exempt from tax when withdrawn, since it is taxed before it is contributed. Balances in the accounts earn interest annually at a rate determined by the Treasury Department – 4.75 percent for 2008; the interest is taxed when withdrawn. Also unlike TSP, the only limit on the amount an eligible participant may contribute to a voluntary contributions account is 10 percent of all basic pay you have received during your federal career.
A voluntary contributions account is similar in many ways to a traditional IRA funded with nondeductible contributions, except with a higher contribution limit. It is also similar to a retail deferred annuity contract except that, as an IRS qualified retirement plan, the voluntary contributions account is eligible for rollover to an IRA.
Most of the obvious benefits of a voluntary contributions account are either not unique or not particularly attractive when compared with other options. But, there is one less obvious way to use a voluntary contributions account to your advantage. Its status as a qualified retirement plan combined with its liberal contribution limit might allow you to increase the benefits you receive in retirement.
Consider an employee – we’ll call him Max – covered by CSRS or CSRS Offset who plans to retire in 2009. Max has accumulated several hundred thousand dollars in savings outside of retirement accounts such as TSP, IRAs or 401(k) plans. He has never made a voluntary contribution to his supplemental annuity account since he wasn’t willing to put significant amounts of his long-term savings into an interest-bearing investment.
Now he is considering a $200,000 voluntary contribution – the maximum possible with his estimated career basic pay of about $2 million – just before he retires. The potential benefit would be to then convert the already-taxed principal to a Roth IRA, thus converting a large amount of retirement savings from taxable to tax-exempt status with little or none of the tax effects that might come from converting a large tax-deferred balance from a retirement plan such as a TSP, 401(k) or traditional IRA account. Here what Max should consider:
- Conversion year income. IRS will allow conversion to a Roth IRA in 2009 only if Max’s modified adjusted gross income is less than $100,000. Since things like tax refunds and leave buyout payments contribute to modified adjusted gross income, this might be a problem. Beginning in 2010, the modified adjusted gross income limit for Roth IRA conversions will be lifted. Max could consider making the voluntary contribution before he retires and then delaying the conversion to a Roth IRA until 2010.
- Balances in other retirement accounts. The goal of avoiding taxes may be lost if Max has large balances in other tax-deferred accounts. If, for example, Max has $200,000 in a traditional IRA with no tax basis at the time he converts his voluntary contributions account balance to a Roth IRA, the IRS will aggregate his
account balances and allow only half of the Roth conversion tax-free. He will be deemed to have converted to a Roth half of his voluntary contribution account and half of his traditional IRA for tax purposes, preventing him from selectively converting only the after-tax part of his overall tax-deferred holdings. He will have to pay tax on the other half in 2009, and this tax must come from funds outside of
the one converted.
- Tax status of taxable savings. Max will accrue the maximum benefit if he can make the voluntary contributions without having to incur taxes to free up the needed cash – for example, using money market funds or certificates of deposit rather than having to sell highly appreciated securities.
- Need for income shortly after the conversion. Amounts contributed to a Roth IRA must remain in the account for at least five years to avoid the early withdrawal penalty. Max should make sure he can meet
his needs without tapping the new Roth IRA for the first five years.
Written by Mike Miles
For the Federal Times
Publication July 21, 2008