Shielding Retirement Savings from Taxes
Joseph Lipsitz, CPA, ChFEBC
For most federal and postal employees (FAPEs), retirement income is generated
from a combination of three sources: a retirement annuity, withdrawals from the
Thrift Savings Plan (TSP), and Social Security (for FERS and CSRS-Offset
employees). While income from Social Security is often partially taxable,
the annuity and TSP withdrawals are fully taxable at ordinary income
rates. Because of the impact of taxes, some FAPEs think of these
retirement accounts as joint accounts that they co-own with the federal
government.
As the adage goes, taxes are one of the two things in life that are
certain. This certainty means that if tax rates increase, FAPEs may see
the legs cut out from under every source of their retirement income. As an
example, if Fred the Fed has a retirement annuity of $20,000, this is worth
$16,000 to him at a 20% tax rate. But, if his tax rate increases to 25%,
his annuity will only be worth $15,000. The $20,000 figure becomes
meaningless: all that should really matter to Fred is what he receives after
taxes.
So what will FAPEs have after taxes? Since no one can assure the future
tax rates that Congress will set, it is important to consider the impact taxes
can have on retirement income, and more importantly, what preventative action
FAPEs can take now to secure tax free income in retirement.
The retirement income that FAPEs expect to generate from their retirement
annuity, TSP, or Social Security is at risk if tax rates increase. Many
FAPEs have never been told that they can utilize a Roth IRA to minimize the risk
of increasing taxes and curb the extent to which taxes invade their retirement
income [i].
Before considering any other retirement savings, FERS employees must
contribute at least 5% to the TSP to garner the benefit of the 5% match from the
government. A 2007 survey ordered by the TSP's governing board indicates
that 13% of FERS employees made no contributions to the TSP in the two years
preceding the survey [ii]. This is shocking
considering a FERS employee earning $30,000 who contributes only 5% of her
salary per year for 30 years can accumulate over $400,000 [iii].
The TSP survey also indicates that tax benefits are the number one reason why
FAPEs contribute to the TSP [iv]. It may be a
surprise to these respondents that many FAPEs would obtain a greater tax benefit
by utilizing a Roth IRA instead of the TSP. In fact, the survey found that
60% of federal employees favor adding a Roth account to the TSP [v]. Of course, Roth IRAs are available outside of
the TSP to FAPE's with an adjusted gross income of less than $105,000 (or
$167,000 for married joint filers).
FERS employees who are
interested in saving more than 5% of their salary, CSRS, and CSRS-Offset
employees should consider how a Roth IRA might be beneficial to maximizing their
after-tax income in retirement. At the least, a Roth can add tax diversification
to a retirement portfolio by reallocating savings that would have been taxable
to a tax free retirement account.
In addition to providing tax-free income in retirement, Roth IRAs also have
two key additional benefits:
1. Investment Options
The TSP offers 5 investment options in the C, S, I, G, and F Funds (and their
targeted allocations in the L Funds). With a Roth IRA, the majority of the
investment universe is available, including thousands of mutual funds (and those
that the TSP funds are designed to track). In particular, the risk reduction
options in the TSP leave FAPEs with little choice aside from shifting their
allocation toward the F and G Funds.
2. No Required Minimum Distributions (RMDs)
Since FAPEs have not paid taxes on money saved in the TSP, the federal
government requires distributions to be made and taxes to be paid beginning at
age 70.5, whether the retiree wants to take the distribution or not. A Roth
allows earnings to continue to grow tax free throughout the employee's lifetime
and for tax free withdrawals to continue for an heir.
Fred and all FAPEs have a choice for their retirement savings: either pay
taxes now and grow tax-free income for retirement, or take a tax deduction now
and pay taxes in retirement. To reduce overall tax liability, FAPEs should pay
taxes when rates will be lowest, either now (by using a Roth IRA) or in
retirement (by using the TSP).
This begs the question, how does Fred know what his tax rate will be in
retirement? The rate at which individuals pay taxes is dependent on two primary
factors: the tax rates set by the government and the individual's income. Since
we have no sure way of knowing what the government will do, I will leave it to
the readers to consider the comparable likelihood of the government lowering
taxes as compared to raising taxes. Contributions to the TSP are subject
to taxation at whatever the future tax rates may be. Roth contributions
eliminate the risk that increasing tax rates could have on your future
retirement.
As for whether a FAPE will have a higher income now or in retirement, this is
a calculation that each FAPE should make by including all expected sources of
retirement income.
In short, FAPEs who think that tax rates may increase or that their income in
retirement may be higher than their current income may be able to minimize the
impact of taxes by utilizing a Roth IRA to supplement TSP savings.
The decision whether to add a Roth IRA to your retirement plan is an
important one that FAPEs do not need to make alone. In the TSP Survey,
over 50% of participants cited the need for professional tax
assistance [vi], and for those folks, I
recommend a Certified Public Account (CPA) or financial advisor who knows and
understands federal employee benefits.
About the Author
Joseph Lipsitz, CPA, ChFEBC
Joseph Lipsitz is a
Registered Representative with L&M Financial Services in Amherst, New York
and Securities America Inc. He is a Certified Public Accountant (CPA) and
Chartered Federal Employee Benefits Consultant (ChFEBC) who focuses on helping
federal and postal employees make smart retirement decisions. Joseph can
be contacted via email at JLipsitz@lmfs.net.
Securities offered through Securities America Inc., Member
FINRA/SIPC and advisory services offered through Securities America Advisors,
Inc. Joseph Lipsitz, Representative. L&M Financial Services and
The Securities America Companies are unaffiliated. 02/10 SAI #
148731. A ROTH IRA may not be suitable for all investors, and may carry
tax implications. Please contact a tax professional in your state
concerning your specific
situation.
[i] For taxation purposes, the
TSP is similar to a traditional IRA: contributions to these accounts are
eligible for a tax deduction in the year and the amount of the contribution, and
withdrawals are fully taxable as ordinary income.
As an example, Fred the Fed is a federal employee earning a
salary of $40,000 in 2010. Fred contributes $1,000 to the TSP, so he will have
to pay taxes on only $39,000. Whether Fred's $1,000 retirement savings goes up
or down in value, he will have to pay taxes on any amount withdrawn. The higher
the account value, the higher the tax liability as these funds are
withdrawn.
The TSP and traditional IRA are called tax deferred accounts
because payment of taxes is deferred until the time the money is
withdrawn.
A Roth IRA works in exactly the opposite way for tax purposes:
there is no deduction for contributions, but all qualifying withdrawals from the
account in retirement are tax free. To further the example in the last
paragraph:
Out of his $40,000 salary, Fred makes a $1,000 contribution to a
Roth IRA. In this case, he will have to pay taxes on the full $40,000 of income.
However, qualifying withdrawals from this account in retirement are completely
tax free to Fred, even if the account increases in value.
[ii] The results of the TSP
Participant Survey are available through a link on the TSP's website at
tsp.gov/curinfo/pressrel/2007Jan16_TSP-survey-results.html.
[iii] Assuming 3% annual salary
increases and 7% growth.
[iv] The results of the TSP
Participant Survey are available through a link on the TSP's website at
tsp.gov/curinfo/pressrel/2007Jan16_TSP-survey-results.html.
[v] IBID
[vi] IBID
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