Years back there was a series of commercials featuring an auto mechanic (most likely an actor dressed as one) telling viewers to buy a certain brand of oil filters, concluding with a warning that “you can pay me now or pay me later.”
The message was that if you wait, you will end up paying much more to repair the eventual damage to your engine from dirty oil.
Pay now or pay later is also the essential decision regarding investing in retirement savings programs such as the federal Thrift Savings Plan. Do you pay taxes now, or pay them later?
The TSP offers two types of balance. Both provide a substantial benefit to investors, allowing earnings to compound without reductions for taxes over the years.
In “traditional” balances, investments come from pretax dollars. The up-front tax break for employees, particularly higher paid ones, can be substantial. On withdrawal, that money along with the earnings is fully taxable.
In “Roth” balances, investments are made with after-tax money. On withdrawal, those investments are tax-free. So are the earnings if certain conditions are met (the withdrawal is made at least five years after the beginning of the year in which the first Roth investment was made; and the participant is at least 59 ½ years old, disabled or deceased).
Recent debate on Capitol Hill over tax policy has highlighted just how important that choice can be. One idea to get more money coming into the government up-front—to help offset the lost revenue from cutting taxes elsewhere—involved limiting how much money could be invested into traditional balances. There were suggestions of setting a much lower threshold than what applies now–$18,000 in 2017, $18,500 in 2018, plus $6,000 more for those age 50 or older in the pertinent year—and requiring that anything above that be invested on an after-tax basis.
Those ideas fell by the wayside (for now, at least), largely because sponsors came to realize that while generating more tax revenue in the short run, Roth investments generate less in the long run.
But the discussion should serve, if nothing else, as a reminder that there is a choice involved here, one with serious long-term implications to a person’s retirement finances.
Here’s how a report from the Center for Retirement Research puts it:
“The most obvious issue of perception is that contributions to traditional 401(k)s immediately cut the participant’s taxes. Roth 401(k)s do not provide tax relief today and therefore may not seem as appealing to the typical participant. On the other hand, it is nice to know that the money in your account is the amount you will have available to spend. To the extent that no further taxes are required on a Roth account, the full amount is available for support in retirement. Funds in a traditional account will be taxed upon withdrawal, so the amount available for support is always less than the account balance.”
TSP investors in effect make that choice every day—more accurately, every pay period—by deciding whether to invest in one way, the other, or both—and if so in what proportion. Investors at any time may change their form of investment, so long as the combination of the two doesn’t exceed the annual limits. Deciding not to change is a decision, too.
The main advantage of traditional investing is that generally, retirees are in lower tax brackets and thus will be paying tax at a lower rate when they withdraw the money. The main advantage of Roth investing is the tax-free withdrawals. (Also, unlike in a Roth IRA, there are no income limits on eligibility to participate in the TSP Roth feature. Thus, for higher-earning employees, the TSP Roth feature may be the only opportunity to make Roth-style investments.)
It’s a complicated decision and one that has variables outside the investor’s control.
Says the report, “In terms of future taxes, the tendency is for individuals to think that they will be living on less in retirement so their tax rate will be lower. But the tax system is dynamic, and a future Congress may well raise taxes – particularly in light of growing federal budget deficits. It is not possible simply to assume the current tax system will be the same decades ahead. In short, enormous uncertainty surrounds whether today’s workers will face higher or lower tax rates once they stop working.”
Such complexity may be the reason that the Roth choice is so little used in the TSP. Of the above $500 billion on account in the TSP, only $8 billion, less than 2 percent, is in Roth balances.
Even that is skewed by the high rate of Roth balances among military personnel. They can invest combat zone pay, which is tax-free to begin with, in a Roth balance and thus never pay taxes on that money or its earnings. The average FERS employee balance is about $130,000, of which on average about $10,000 is in a Roth balance. For military personnel, the figures are about $22,000 and about $6,000, respectively.
Some of the heavy tilt toward traditional investing represents the fact that up to 2012, that was the only type allowed in the TSP; money already in an account can’t be recharacterized from one to the other. Some of it reflects the fact that employer contributions for FERS employees are made into traditional balances regardless of how the account holder is investing.
But another factor is that traditional investing is the default; Roth-style investing requires an affirmative choice. In essence, by doing nothing TSP investors have overwhelmingly decided not to pay taxes now.
But that doesn’t mean they won’t have to pay them later.