Joseph Lipsitz, CPA, ChFEBC
May 24, 2010

For young workers, a Roth IRA is the closest thing to a financial free lunch that exists under today's tax rules.  By investing in a Roth instead of the TSP when appropriate, federal employees can easily accumulate an extra $100,000 in retirement savings by doing essentially nothing.

When I begin working with Federal and Postal Employees (FAPEs), my goal is to show them how they can continue to draw the same amount of inflation-adjusted income when they retire as they did in their last year on the job.  After all, if you have a satisfying qualify of life and can afford to continue to do so indefinitely, retirement seems really sweet.  But sustaining quality of life means that a retiring Fed will need a financial plan to generate an increasing annual income and meet increasing costs of living. 

Most young FAPEs cost themselves many thousands of dollars by saving for retirement the wrong way, namely by pouring money into the TSP and crossing their fingers.  It seems that saving for retirement in the tax-deferred TSP plan is conventional wisdom.  However, a basic understanding of the differences between the TSP and a Roth IRA can help young FAPEs see that "conventional ignorance" may be more apropos. 

Before continuing with the show, it is imperative that you understand the difference between the Thrift Savings Plan and a Roth IRA.  More importantly, you must never forget my rule after which all others follow: if you are a FERS employee, you must contribute at least 5% of your salary to the TSP.  If you are not absolutely clear on the difference between pre-tax and after-tax retirement savings, please read my previous article.  If you are still not clear, please read no more and skip from here to the very last sentence of this article, before the Q&A. 

As basically as possible, a tax-deferred plan like the TSP allows FAPEs to defer paying taxes until retirement.  A Roth allows folks to pay the tax upfront and receive the accumulated value tax-free in retirement. [i]  So, we return to the question that was the topic of my prior article: would you rather pay taxes now or later?  To be clear, there is a right answer to this question for young FAPEs, and the answer is unequivocally now. 

As we revisit my poetic client, Fred the Fed, it is important to note that there is a cost for a Roth contribution, and that cost is taxes.  At the beginning of his career, let's assume Fred is age 23 and earning a $30,000 salary.  After contributing the mandatory 5% to the TSP, Fred has decided to save an additional 10% of his salary equaling $3,000 for retirement.  If Fred contributes this $3,000 to the TSP, he will not owe any taxes on the contribution until he withdraws the money.  If Fred decides to contribute to a Roth IRA instead, the $3,000 will be taxable as income now (likely at a 15% rate) so only $2,550 ($3,000*(1-0.15)) will go into the Roth.  To make an apples-to-apples comparison, I will consider a $3,000 TSP contribution and a $2,550 contribution to a Roth, since the after-tax cost of both contributions equals $3,000.

Assuming Freddie (that's what his friends call him) works until age 60, we can compare the value of equivalent investments in the TSP to a Roth IRA.  It is important to understand that the value of retirement savings is in your real deal, after-tax, take-home income.  After all, a huge retirement savings is only valuable to the extent that it allows the saver to buy things, not pay taxes. 

Notice the power of compounding interest that triggers the growth of a $3,000 contribution to over $55,000 during a normal working career.  Also notice the bottom row, which is where the real comparison takes place.  As you can see, if Fred's tax rate does not change from age 23 to age 60, he will be substantially as well off using the TSP as a Roth IRA.  In this case when all seems equal, I recommend a Roth IRA for the investment options and avoidance of compulsory distributions. 

Analysis 1 is an unrealistic example to illustrate the effect of unchanging tax rates, which almost certainly will change during Fred's career.  The two key factors in determining Fred's future tax rate - 1) his income and 2) the rates set by Congress - will both likely shift upward as he approaches retirement.

While we cannot know for sure what Congress will do with tax rates, I do know that in 38 years [iii], Fred will be earning more income than he is today.  With details relegated to the endnotes [iv], Fred will retire at age 60 on an income of approximately $98,000 without doing anything extraordinary.  An income at this level will most likely bump Fred into a higher tax bracket, so for the purposes of this example, I will assume a marginal tax rate of 25%. 

Since Fred paid taxes at a 15% rate (at age 23) instead of a 25% rate (at age 60), a Roth will provide him with $5,587 ($47,494 - $41,907) more in real deal, after-tax income in retirement than the TSP.  If he continues contributing to a Roth for as many years as it is advantageous to do so, this amount can quickly grow beyond tens of thousands of dollars.  Keep in mind this is money that Fred was saving anyway, and the additional $5,587 is simply bonus for doing things in a tax-advantaged way.  For people who do not expect tax rates to decrease in the coming decades (and I've met no such people), it makes sense, as a general rule, for most FAPEs to pay taxes at a 15% rate whenever they have the chance to do so [vi]. 

Since Fred will earn more in retirement than he does now, we can expect him to pay taxes at a higher rate.  However, most people believe that current tax rates will increase, so let's take a look at what happens if rates increase to 30% for Fred's income level in retirement:

This shows that the higher tax rates are in the future, the greater the benefit of a current Roth contribution.  In this case, with Fred's future tax rate increasing from 25% to 30%, the Roth will generate $8,382 more real, after-tax income than the TSP.  Again, this is only one year's contribution, and it will probably make sense for Fred to do this for at least the first 15 years of his career. 

This is where things can get a bit more technical.  When saving for retirement, many investors make the costly mistake of assuming their investment time horizon is the duration from today until their retirement date (a fatal fallacy which I will discuss in a future column).  In all cases I have seen however, FAPES never withdraw all of their retirement savings on their first day of retirement.  This means that the actual investment time horizon is from today until when funds are withdrawn, either to meet expenditures in retirement or as a compulsory distribution (at age 70.5). 

Since Roth IRA investments can continue to grow tax-free and are never subject to compulsory distributions, it almost always makes sense to withdraw the Roth money after all taxable funds (for example, in the TSP and traditional IRAs) have been withdrawn.  This allows the value of the Roth to continue to grow.  So if we assume that Fred does not begin withdrawing money from his Roth IRA until his age 70, that will allow the money 48 years of tax-free compounding growth, like this:

In this analysis, we see that longer periods of time until withdrawal (not until retirement) can amplify the benefit of a Roth.  Going back to a 25% tax rate for this example, Fred will have an additional $12,064 at age 70, and the longer the period until he uses his money, the greater the difference will be.  Again, this is only one year's contribution, and you can see that a savings of $12,064 in a single year can easily sum to six-figure savings over a decade or more.   

If Fred continues to use a Roth as long as his salary keeps him in the 15% tax bracket [vii], we can use the same calculations to show that he should contribute to a Roth IRA for at least the first 15 years of his career (at current tax rates).  Using the same assumptions as above, Fred can accumulate an extra $150,372 over his career by utilizing a Roth instead of the TSP (of course, after the mandatory 5% TSP savings for FERS employees.)  While this amount seems staggering, it looks even better for any subtle increase in future tax rates, investment returns, and in the time until the investor withdraws the funds. 

To be sure, there are several additional benefits and intricacies to Roth IRAs, some of which are addressed in my previous article linked above.  But if you are a young FAPE under age 30, I hope your only question is "How do I set up a Roth IRA?"  For this and other financial planning questions, my answer will never change: find an advisor you can trust, who understands your benefits as a federal employee. 

Now for a brief Q&A with myself (and I will also field questions at my email address below):

Q:  If I'm not a young FAPE, should I use a Roth IRA?

A:  Maybe.  For FAPEs with higher salaries approaching the end of their careers, a Roth may or may not make sense.  The ramifications of the decision to use or not use a Roth IRA can amount to tens of thousands of dollars (or more) for you and your family, which is orders of magnitude more than the fee for most financial planners I know.  For the do-it-yourselfers, determine your current tax rate and compare it to your expected tax rate when you plan to use the funds in retirement.  If the retirement rate is the same or higher than the current rate, a Roth IRA could make good sense.  A Roth IRA can also work wonders for money you are intending to pass along to the next generation.

About the Author

Joseph Lipsitz, CPA, ChFEBC ( JLipsitz@lmfs.net )
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.  04/10.  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.  SAI # 175759  04/10

[i] Retired FAPEs can begin withdrawing funds from the TSP with no penalty at age 59.5.  All withdrawals from the TSP will be taxable at income tax rates.  Qualifying withdrawals from a Roth IRA are tax-free.  Withdrawals after age 59.5 from accounts that have been opened for more than five years qualify. 

[ii] 8% is merely a conservative guess based on historic equity returns.   
  
[iii] Fred is 23, and he is retiring at 60.  I know that 60-23 is 37, not 38.  However, Fred is 23 during his first year of employment, 24 during his second year, 25 during his third year, and 60 during his 38th year. 

[iv]  With a 2.75% salary increase per year, Fred (since he's a FERS employee) will retire on an inflation-adjusted pension of about $33,000.  Since we know Fred to be a good FERS employee, he has contributed 5% of his salary to the TSP, which has accumulated to a value of about $975,000.   From the TSP balance, I would suggest he plan to draw approximately $45,000 per year.  For his FERS supplement or Social Security, I'll estimate an additional $20,000 per year of taxable income.  In this example, I assume TSP contributions of 5% per year and growth of 8%.  For Social Security, by today's calculations, this is a very low estimate.  I tent to err on the side of conservativeness with these estimates because of the uncertain future of Social Security Calculations.  At a maximum, 85% of Social Security income is subject to taxation.

[v]  For simplicity, I assume a tax rate of 25% since tax on most of this income would be paid at a 25% rate, with a portion paid at 28%.  
  
[vi]  The exception to this rule is older FAPEs who pay taxes in the 15% bracket now. 

[vii]  2010 federal tax brackets require single taxpayers (married filing a joint return are in parentheses) to pay 10% on income up to $8,375 ($16,750), 15% from $8,375 to $34,000 ($16,750 to $68,000), 25% from $34,000 to $82,400 ($68,000 to $137,300), 28% from $82,400 to $171,850 ($137,300 to 209,250), 33% from $171,850 to $373,650 (209,250 to $373,650), and 35% from $373,650 and above.  

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