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TSP ROTH Conversions. Why military folks benefit more. (Part 2)

Updated: Jan 18, 2022

In TSP ROTH Conversions. Why military folks benefit more. (Part 1) we looked at the general concept of pretax retirement accounts versus Roth IRAs and some of the most significant factors to consider when contemplating whether a Roth conversion is advantageous for your family.

Now we examine a hypothetical case study using a recently transitioned military couple.

John is 47 and retired as an O5 with 25 years of service. John’s spouse Susan is also 47 and will remain a stay-at-home mom until their two kids go to college when she’s 51 and then will return to work outside the home for $75,000 per year and maximize her pretax contributions in a 401K with a 3% match. The couple’s pension is $75,000, and John is now working in a second career and making a $175,000 salary. He’s putting the pretax maximum allowable in his 401K and getting a 3% match. They have accumulated $500K in their pretax TSP and are considering rolling it into an IRA and then into a Roth. Their 401Ks allow in-service rollovers, so they will also consider converting their 401K contributions and gains annually as long as it doesn’t drive their income above the 32%/33% tax bracket. The expected return of their portfolio is 7.5% per year. To consider as many variables as practical, we put their information into financial planning software to see the probable impact of the Roth conversions. Figure 1 below is a graphical model of the Smith’s Roth conversion scenario.

Figure 1. The impact of the Smith’s Roth conversion

Notice that the blue line in Figure 1 above shows the adjusted taxable income with the Roth conversion, while the green is the taxable income without the Roth conversion. As the couple converts deferred income into a Roth IRA in the earlier years, they’ll have a higher adjusted taxable income and pay more in taxes. However, as you can see by the fact that the blue line drops off well below the green as the couple retires at 65, their taxable retirement income becomes much lower than it would have been if they had not converted to a ROTH.

Figure 2 below shows the taxes the couple will pay over the years with the two scenarios. Notice how the blue line (with Roth conversion) has the couple paying substantially more taxes than the green line (no conversion) up until retirement but then substantially fewer taxes after retirement. The net effect for this scenario is that the couple saves about $1.6M (today’s dollars) in taxes by converting.

Figure 2. Taxes with and without Roth Conversion.

Now let’s calculate the expected ending value of the portfolio. This assumes the Smiths spend $160K a year in today’s dollars during retirement. As you can see in Figure 3 below, the estimated ending value is about $1.1 million higher (today’s dollars) when converting the pretax funds to a Roth. This is shown in Figure 4 below with the Roth conversion being the “Proposed Plan.”

Figure 3. Estimated projected ending values in today’s dollars.

So why does this situation with this military couple make their case for Roth conversions so compelling? In TSP ROTH Conversions. Why military folks benefit more. (Part 3) we’ll examine the reasons a Roth conversion is especially attractive to this couple and why similar factors may be quite common among military families.

Disclaimer: Nothing in this blog should be considered financial advice or recommendations. Your questions are unique to you and your own personal financial circumstances. You should consult with a financial professional before making a financial decision. See full blog disclaimer.

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