A roth gives you options to manage your tax liability in retirement when taking distributions. Image: Michail Petrov/Shutterstock.com
By: Lisa Whitley, AFC, CRPCWe’ve all heard it: A Roth (post-tax) retirement account is the best thing since sliced bread. (Fun fact: I lived in Zimbabwe in the late 1990s when sliced bread debuted in the country. It really was a sensation!) And with TSP now offering a Roth option, many federal employees who were previously locked out of using a Roth because of their household income are now giving it another look. And that’s good, because a Roth gives you a simple way to take a lump distribution with added flexibility.
There is much to love about a Roth account: You never pay taxes on earnings, and you lock in the certainty of today’s tax rate on your contributions (which may or may not be a plus; only time will tell).
(Of course, it is not quite as straightforward as that. There are situations when regardless of your view of current versus future tax rates, it makes more sense to “go traditional” and lower your adjusted gross income in the here and now. Two popular reasons are to qualify for tax credits when paying college tuition for your child, and maximizing your benefit under the Public Service Loan Forgiveness (PSLF) program.)
But even if you are fairly convinced that there is very little benefit for you to use a Roth account (for example, you do not foresee that your tax rate will be higher in retirement), I would still implore you to give consideration to diversifying the tax treatment of your retirement savings.
Why? Because of the third “thing to love” that I did not mention above — the ability to dynamically manage your tax liability in retirement when you are taking distributions. This is important for almost everyone with sizeable retirement savings, and especially a nest egg combined with taxable federal pension income.
You may be perfectly satisfied with your retirement marginal income tax bracket (to the extent that one can be!) as you take regular, planned distributions from your traditional TSP account. But the day will surely come when you will have a large, lumpy expense. It may be a new car, a dream vacation, a home renovation, or a grandchild’s college tuition. And that extra five-figure distribution may push you into a higher marginal tax bracket. For example, for a married couple, the breakpoint between the 12% tax bracket and 22% occurs when your income exceeds $94,300 (in 2024).
For those who have chosen to take Medicare Part B in retirement, in 2024, even one dollar of adjusted gross income over $103,000 ($206,000 if married) exposes you to an additional premium surcharge known as IRMAA (Income-Related Monthly Adjustment Amount).
Even if that does not occur, you will likely be distressed by the sheer size of the tax bill. A $40,000 withdrawal will be subject to an automatic 20% federal withholding; you will actually need to remove $50,000 from your portfolio to meet your need. (And, of course, find the funds to make an appropriately sized estimated quarterly tax payment to your state on top of that.) Even if you calculate that your effective tax rate is much lower and that this withholding will eventually result in a refund come spring tax season, in the moment, that super-sized distribution is going to feel painful. More analytically, you will have lost the potential investment earnings on the “extra” $10,000.
Wouldn’t it just be easier if you had a well that you could go to for that large check, without any further thought of the tax implications? That would be your Roth account.
Although you may believe that all the usual reasons to have a Roth account do not apply to your situation, take another look. If you are still working and contributing to your TSP, you can build your Roth nest egg going forward. (You certainly need not use Roth for 100% of your future contributions if you prefer not to.) On the other hand, near-retirees (or retirees) will have to decide if a Roth conversion makes sense, a more complex equation.
The rules of investing, as always, are simple: Don’t put all your eggs in one basket. In this case, this maxim means having not only a diversity of “eggs” (investments) but also more than one “basket!”
Lisa is an Accredited Financial Counselor (AFCⓡ) and Chartered Retirement Planning Counselor (CRPCⓡ). After an 18-year career as a Foreign Service Officer with the United States Agency for International Development (USAID), Lisa became a personal finance coach in 2019. Since then, she has counseled hundreds of people on topics such as retirement, budgeting, debt, paying for education, and more. She has established her own firm, MoneyByLisa, a Registered Investment Advisor domiciled in the District of Columbia.
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