Many people have taken advantage of the Roth TSP option since its inception in 2012. However, there are still many federal employees and service members with most of their retirement savings in traditional accounts. Naturally, this begs the question: “How do I convert my traditional account to a Roth account?” This is also known as a Roth conversion.
The more appropriate approach should be to ask two questions:
- Should I convert my traditional account to a Roth account?
- If so, how do I do this in the most effective manner? Effective manner indicates minimal loss of money through fees, taxes, etc.
As with most questions, the correct answer is not straightforward. Rather, it’s an answer that depends on the person’s (or family’s) particular financial situation, goals, and values.
Roth Conversion Point #1: You’ll have to do it outside of Thrift Savings Plan (TSP)
While TSP allows people to choose either Roth or traditional contributions, it does not allow Roth conversions. Since TSP doesn’t allow Roth conversions, you’ll have to establish (or use an already established) Roth IRA account.
You can find any number of low-cost providers online. However, you should evaluate the increased costs of managing within an IRA versus TSP.
Roth Conversion Point #2: Combat Zone Contributions
Many people have tax-free contributions from combat zone earnings. If tax-free contributions are a significant part of the TSP account, there are four major considerations:
1. IRA custodians only track pre-tax (traditional IRA) and post-tax (Roth IRA) accounts. When it comes to the tax treatment of your distributions, do not expect your IRA custodian to get it right. You’ll probably need to keep meticulous records, or hire a tax professional or financial planner to help. Or, you can follow this guide to maintain the tax-exempt status of contributions when you do an IRA rollover. This is an advanced tax strategy and it’s worth enlisting assistance to ensure you do it correctly.
2. There is no true tax benefit to converting tax-free contributions to a Roth account. The primary tax benefit of a Roth account is to avoid paying taxes on distribution. Since the IRS does not tax combat zone contributions upon distribution, there is no additional benefit in this regard. There are, however, other Roth benefits, such as RMD avoidance and unlimited withdrawals of contributions/conversions under qualifying circumstances. That said, if you convert tax-exempt contributions to a Roth IRA, all earnings on those contributions become tax free.
3. You can’t choose between TSP distributions of pre-tax, post-tax, or tax-free contributions. According to IRS Notice 2014-54, “any distributions from retirement accounts must be proportionally drawn from pre-tax and post-tax accounts.” IRS Notice 2014-54 doesn’t specifically discuss tax-free accounts. However, the TSP website clearly states that withdrawals will contain proportional amounts of Roth, traditional, and tax-exempt contributions.
4. While combat zone contributions are tax-free, earnings on these contributions is fully taxable. This is a true statement if the tax exempt contributions remain in a Traditional account. If you convert them to a Roth account, earnings after the conversion will become tax free as well.
Roth Conversion Point #3: Tax Planning
This is probably one of the most important, yet most overlooked, considerations. The entire purpose of tax planning is to minimize tax liability. In order to do this properly, you have to look at this from a long-term perspective. Usually, this is done through a balance of:
- Deferring the recognition of income
- Taking advantage of tax incentives, such as deductions or credits, or
- Shifting the recognition of income to take advantage of the lowest possible tax bracket
Roth conversions actually force the recognition of income earlier than needed. This directly violates the first principle. Since that’s true, there needs to be a really compelling set of circumstances that follow one of the other principles.
However, there are many cases in which people just want to get to the tax-free distribution benefit of a Roth. In doing so, they may overlook the fact that they will pay:
- More money than they need to
- Sooner than they need to do it
A tax-efficient approach helps people use a multi-year approach. This ensures that Roth conversions usually are done at the lowest possible tax bracket. The expectation is that distributions occur when the earner is in a higher tax bracket.
Roth Conversion Point #4: Tax Bracket Projection
To continue the previous point, Roth conversions work best when you know that your future tax bracket will be higher than the current one. Many people get this wrong. They make Roth conversions during high earning years (high tax bracket), so they can have tax-free distributions during their retirement years (low tax bracket).
It’s worse when you observe that many of these balances contain contributions from lower tax years. In these cases, these folks are paying more than if they had directly contributed to the Roth account. And, they’re paying taxes sooner than if they had decided to take distributions (or make a conversion) later on. That’s the worst of both worlds.
Fortunately, most servicemembers have a better opportunity. Usually (although not definitely), military families are in lower tax brackets (compared to their peers) over the course of their careers. Then, when they retire, many folks see an unexpected jump in income (and tax bracket). Doing a Roth conversion after you’ve already seen a significant post-military jump in tax bracket can lead to paying more in taxes than you should.
Instead, it might be worthwhile to do your conversion during a low income year, such as a deployment year. In most cases, it’s definitely worth evaluating the possibility of doing your Roth conversion over multiple years, while you’re on active duty.
Roth Conversion Point #5: Why Do I Need to do Anything?
Many people spend most of their career saving their hard earned money, just to find out they’ve reached a point where they feel they can’t spend it all over their expected lifetime. Between military pension income, Social Security income, and other income sources, these folks find they have more than enough income to meet their needs. Then, they reach age 70 ½, and face required minimum distributions. Now, they’re stuck recognizing and paying taxes on income they don’t need or want.
That’s the whole point of converting to a Roth IRA, right? You pay the taxes up front so you don’t have to pay any down the road. While that might be true, here are some considerations:
- How sure are you that the taxes you’re paying down the road would be more than what you’d be paying now? First, think dollars to dollars, using Point 4 above. Just as importantly, think about the time-value of money.
- Your IRA account grows without tax consequence. The IRS only taxes IRA distributions. Worst case scenario, your traditional IRA is growing in a tax-deferred manner. You’re only taxed when the money is distributed. This point is important enough to re-emphasize: “Your money grows without tax consequence while in your IRA.” I hear people say they converted to a Roth IRA to enjoy the tax-free growth of their money…your money grows tax free in a traditional account too. Additionally, since it was pre-tax money, you have more of it working for you over time.
- If you’re charitably inclined, you have options. Say you’ve got more money than you know what to do with, and now you’re forced to take withdrawals. Simultaneously, you’ve always wanted to give back to a cause that you believe in. With qualified charitable distributions (QCD), you can withdraw up to $100,000 under a QCD. For married people, this is $100,000 per person, as long as the money comes from separate IRAs. This is specifically for people who reach age 70 ½ and want to avoid RMDs.
- If you’re looking into long-term care or are worried about outliving your money, longevity insurance is an option. Longevity insurance, in the form of a qualified longevity annuity contract (QLAC), can be a very attractive investment for people who are worried about outliving their money. A QLAC allows an investor to invest in an annuity at an older age (usually 65-70), then start receiving payouts at a later age, as late as 85. While the details of a QLAC are too much for this article, this could be a means to ensure that you don’t outlive your money while deferring your RMD.
- How sure are you that the tax rules will stay in place until you retire? Let’s look at a brief history of retirement accounts:
- 1974: Traditional IRAs were established under the Employee Retirement Income Security Act (ERISA)
- 1978: 401(k)s were established
- 1986: TSP is established as part of the Federal Employees’ Retirement System Act
- 1997: Roth IRAs were established as part of the Taxpayer Relief Act
- 2001: TSP becomes available for servicemembers
- 2012: Roth TSP options become available
- 2018: Employer contributions become available for military TSP accountholders
If you were a twenty-something employee back in the 1970s (or 80s, 90s, etc.), you probably would have never foreseen some of the opportunities that have happened over the past 40 years. If you’re a twenty-something servicemember today (or 30-something or 40-something), you should be asking yourself:
How sure am I of the future? Am I willing to pay taxes today in exchange for a benefit that might be different tomorrow?
For those of you harboring doubts, all you need to do is look at Social Security reform, military retirement reform (remember the Final Pay retirement system? No one does, anymore), to know that there are times when the government tries to claw back money when it sees an opportunity. Conversely, the above list of opportunities shows there are also times when the government is looking for ways to entice people to save for their future.
Bottom line: The only certainty is the taxes you’ll pay today on a Roth conversion. Currently, you can defer that choice and let that money grow tax-deferred. Whether that is a wise move or a move you might wish you could take back is a matter of future changes that no one can predict. The younger you are, the more you should take this under advisement.
This primer is by no means a substitute for sound financial advice based upon an analysis of your particular situation. Tax planning can be a very demanding undertaking, particularly if you want to maximize your after-tax income. If that’s your objective, you may want to discuss in more depth with a fee-only financial planner in your area. If simplicity is your primary goal, you may want to get a second opinion. Just keep in mind that it’s easier to postpone this decision than it is to undo it.