TSP ROTH Conversions. Why military folks benefit more. (Part 3)
Updated: Jan 18, 2022
In our last post, TSP ROTH Conversions. Why military folks benefit more. (Part 2), we looked at a hypothetical case study of a Roth conversion decision for a family that just retired from active duty. We saw that in their case, the Roth has the potential to save them significant taxes (estimated at $1.6M current year dollars) and result in a significantly higher ending value ($2.6M versus $1.4M in today’s dollars.). So why did the conversion make such a big difference in their case?
There are two main reasons the Roth conversion alternative is especially beneficial for this couple.
1. Roth IRAs don’t require required minimum distributions (RMDs) like Regular or Roth TSP/401Ks do). If this couple’s retirement were funded primarily by tax-deferred retirement plans, they’d need distributions to live on, so not requiring RMDs would not be much of an advantage. However, this military couple has fixed pension/social security benefits that make up a substantial portion of the retirement income needs. The significant fixed retirement income means the Roth IRA retirement accounts that don’t have RMDs can grow tax-free. In fact, by the time of their life expectancies, all the couple’s remaining retirement money is projected to be in Roths and would pass to heirs without income tax liability. Also, with the Roth conversion scenario, RMDs are not driving their income up into higher tax brackets in the later years. See the significant difference in taxable incomes between the two scenarios in the later years in Figure 1 below.
Figure 1. Adjusted taxable income with (blue line) and without (green line) conversion.
High tax brackets in retirement. If this family were going to be in a lower tax bracket in retirement, a Roth would likely not be a wise move, and they’d probably be better of deferring the income until after retirement. However, this couple has a substantial pension/social security income, and if they don’t convert those tax-deferred accounts to Roths, they will eventually result in significant taxable RMDs at higher tax rates. In Figure 2 below, the top chart shows the effective tax rate without Roth conversions, and the bottom graph shows the effective tax rate with the conversion. The effective tax rate in the later years is much lower with the conversion (18.9% versus 26.5%.). The combination of the effects of the lower tax rate and the lower taxable income results in significant tax savings and significantly higher ending value.
Figure 2. Effective tax rate with and without Roth conversion.
In summary, this military couple has a different retirement income profile than most couples that spend their working lives in the corporate world. This is not uncommon with military families because a good portion of their retirement income is usually provided through pension and social security income rather than RMDs from a 401K. Most of the savings this couple plans to realize from converting to Roth accounts comes from the fact they don’t plan on using much of the money in their Roth accounts during requirement, so not being required to take RMDs saves them a substantial amount. However, every situation is unique, so to determine if a Roth conversion is beneficial, talk to your financial advisor and have them model your scenario.
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