TSP ROTH Conversions. Why military folks benefit more. (Part 1.)
Updated: Jan 18, 2022
Your family has worked hard for that money in your TSP and your military pension. You might have substantial pretax dollars in your TSP or a 401K. You've heard of Roth conversions but aren't sure if it will benefit you. Is it wise to convert pretax retirement money into a Roth? After all, most people are in a lower tax bracket after retiring (myth), so why convert to a Roth when you can just withdraw that money in retirement and pay the taxes then?
The Roth conversion question is complex, so I've broken this blog into three segments. In this post, we'll review the concept of Roth conversions and the factors that determine if we're likely to benefit from converting. In Part 2, we'll look at the case study of a hypothetical military family considering converting a TSP to a Roth IRA. Finally, in Part 3, we'll see how military members often have a retirement income profile that's quite different than their peers in the corporate world and how that fact may make a more compelling case for Roth conversions.
A quick review of the concept of Roth conversions is appropriate. When people save pretax money in an account, it's called a tax-deferred account because they'll pay ordinary income tax on it when they withdraw it. Figure 1 below shows that with a pretax account, a certain percentage is deferred tax liability, and how large of percent simply depends on your tax rate when the money is withdrawn.
Figure 1. A tax-deferred account composition[1]
The main takeaway from Figure 1 is that the entire amount in the pretax retirement account is not all yours. You'll have to pay ordinary income taxes on the whole amount, not just the increase when you withdraw the funds, so a portion of the money is really the US Treasury's. If your tax rate will be 24% percent when you withdraw the money, about a quarter of the account's balance is Uncle Sam's. Uncle Sam's quarter is worth more as the balance grows, just as your 3/4s is worth more. Even if you pass away and leave it to your spouse or children, they'll have to pay ordinary income tax on it when they withdraw it.
Money in a Roth account is treated entirely differently when withdrawn. Qualified withdrawals from Roth accounts are tax-free--both the principal and the gains. The drawback is that you must pay income taxes on the money when you earn it or convert it into a Roth.
So, literally, the million-dollar question is, "should I pay the tax to get my money into a Roth so I can withdraw it tax-free later?" As you can probably guess, the answer is still; it depends. So, what is the answer for your family?
There are multiple factors to consider when considering converting pretax retirement accounts to a Roth account. The two most significant factors are the differences in effective tax rates and the impact of required minimum distributions (RMDs.)
- Effective tax rate. Compare the effective tax rate in the years you're considering converting to the effective tax rate when you'd otherwise withdraw the funds and be taxed. For many people in high-earning years, converting to Roth may mean paying a higher tax rate than withdrawing the money slowly in retirement years when their tax rate might be lower. However, for big savers, and sometimes for military members, their tax rate in retirement may be equal or higher than their current tax rate. Besides Federal taxes, any planned changes in the state of residence and effective state tax rates should also be considered.
- Impact of required minimum distributions (RMDs.) When we turn 72, Roth IRAs don't require required minimum distributions (RMDs) like Regular or Roth TSP/401Ks require. For big savers, RMDs from tax-deferred TSPs/401Ks/IRAs can drive individuals into higher tax brackets during their retirement years and create significant tax bills. There may also be second-order effects such as potential increases in taxes on social security and Medicare.
In TSPs / IRAs and ROTH Conversions. Why military folks benefit more. (Part 2) we will look at a hypothetical case study using a recently transitioned military couple considering converting their TSP to a Roth IRA.
[1] Gains are hypothetical, not guaranteed.
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