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Shielding Retirement Savings from Taxes
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 color=#003366>[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 color=#003366>[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). 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:
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. name=_edn1>About the Author Joseph Lipsitz, CPA, ChFEBC 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 href="mailto:JLipsitz@lmfs.net">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 [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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