The good news is that as of May 7th of this year, the federal government is rolling out a Roth option for federal employees who contribute to the Thrift Savings Program. The bad news: The military doesn’t get to use it. At least, not until late this year.
The Roth account mirrors the powerful tax treatment and benefits in the Roth IRA and the designated Roth account in 401(k) plans in the private sector. Specifically, you can make after-tax contributions to the account. This is different from the standard, traditional TSP in that currently, all TSP contributions are pre-tax. The government deducts your contribution first, and then figures your federal income tax and the amount they withhold from your pay. With the Roth TSP option, they deduct the tax withholding first – and then send your contribution to the TSP. So you still pay taxes on the income, unlike the traditional TSP.
Tax Advantages of the Roth
In exchange, though, you get something very powerful:
Your contributions to a Roth account grow tax-free – for as long as you live. Like the traditional TSP, there’s no tax due on any dividends you receive, nor on any transfers you make between funds within the program. In addition, though, contributions to a Roth TSP mean that there is no tax due on withdrawals you make in retirement. This is in contrast to the traditional TSP account, in which all your withdrawals in retirement are taxed at ordinary income rates.
In addition, there are no required minimum distributions for the Roth TSP. This means that if you don’t need the income from the TSP, you can leave the money in the account as long as you like. The government is not going to make you start taking withdrawals – and paying taxes on them – starting in April of the year after the year in which you turn 70½, like they do for tax-deferred retirement accounts.
Application to the Military
The Roth TSP has special importance to military families who are deployed to a combat zone for all or part of a tax year. Here’s why:
When you are deployed to a combat zone designated as such by the Secretary of Defense, your pay is generally exempt – within certain limits –from federal income tax. It’s simply not counted as adjusted gross income for federal tax purposes.
This means that all uniformed service members deployed to Afghanistan and certain other hotspots have artificially low incomes for the year. If you deployed early in the year, or if you left the combat zone very late in the year, you may only have a month or two of taxable income. Which, in turn, means you will fall into an artificially low tax bracket.
By using a Roth TSP rather than a traditional TSP, you can effectively pay this year’s extremely low taxes on your TSP contributions, rather than the higher rate you’d get charged had you not deployed. And in retirement, when you would otherwise be paying ordinary income tax on your withdrawals, the Roth TSP under current law lets you pay nothing. Income from the Roth TSP is tax free.
The Rollout Schedule
The catch: You’re going to have to wait until late this year in order to contribute to a Roth TSP as a uniformed service member. This is because DFAS and the larger military services have more complex pay systems and require more testing before they go live with the capability, according to a DFAS spokesperson.
Most DoD civilians, including VA civilian employees, will be able to begin contributions in July.
Members of the Army, Navy and Air Force, and DoA, DoN and Department of the Air Force civilian employees will have to wait until October.
That shouldn’t stop you from opening a Roth IRA, though – and contributing outside of the TSP system. There are income qualifications you must meet in order to contribute to a Roth IRA, but most military families will be able to qualify. You can open a Roth IRA via USAA, of course, or via Vanguard, Fidelity, T.Rowe Price, TIAA-CREF, or any number of other investment companies, and contribute up to $5,000 per year.
The federal government is extremely hungry for revenue. Congress has been looking for ways to increase revenue across the board over the past few years. There are already a number of tax increases in the offing beginning in 2013, including an across the board increase in income tax rates as the so-called Bush Tax Cuts reach their sunset provision and are repealed.
I believe that the trend will continue, as Congress struggles to find funding for Social Security and Medicare benefits for an aging population as the baby boomers enter retirement. The health care bill will also be hemorrhaging red ink over the next ten years and beyond, unless sooner modified, repealed, or struck down by the Supreme Court (which it may well be, come June.)
The Roth TSP allows you to lock in today’s tax rates, and lets you hedge your bets against Congress raising tax rates on your retirement withdrawals in the future.
By Jason Van Steenwyk