Why Transferring Traditional TSP to a Roth IRA Makes Sense for Many Federal Employees

For a federal employee, contributing to the traditional Thrift Savings Plan (TSP) and to a traditional IRA are highly recommended for the purpose of increasing the employee’s retirement savings. An employee who contributes to the traditional TSP uses a portion of their gross salary to contribute, thereby reducing his or her taxable salary resulting in reductions to current year federal and state tax liabilities. An employee who is eligible and contributes to a deductible traditional IRA reduces his or her taxable income resulting in current year federal and state liabilities.

The strategy is to defer paying taxes on before-taxed traditional TSP and IRA contributions and accrued earnings until the individual is in a lower marginal tax bracket. The traditional TSP participant and traditional IRA owner will then come out ahead in “net tax” paid with respect to contributions; namely, the amount taxes saved in the year of contribution will exceed the amount of taxes owed at the time of distribution of the contributions.

READ MORE:

• How Does a Roth TSP Rollover to a Roth IRA Work?
• Using the TSP to Fund a Roth IRA

But this strategy assumes that when the traditional TSP and IRA accounts are withdrawn during the retirement years, the traditional TSP participant and traditional IRA owner are in a lower marginal tax bracket. This is not always the case that a retired TSP participant will be a lower marginal tax bracket. In fact, given today’s low individual federal marginal tax rates, a retirement saver today may be in a higher individual federal marginal tax bracket in retirement compared to the tax bracket at the time the individual saver contributed to the traditional TSP and/or traditional IRA.

This column explains why many federal employees could be in a higher marginal tax bracket by the time they withdraw their traditional TSP and traditional IRA accounts. That being said, a traditional IRA conversion to a Roth IRA and/or a tax-free direct rollover of portions of the traditional TSP to traditional IRA (which is then subsequently converted to a Roth IRA) makes sense for those employees who will be in a higher marginal federal tax bracket in retirement. Note that when a deductible traditional IRA (a traditional IRA in which the contribution was deducted on one’s federal income tax return as an adjustment to income) is converted to a Roth IRA, the traditional IRA owner will pay income taxes at his or her current year marginal tax bracket. This is also true when a portion of the traditional TSP is directly rolled to a traditional IRA and then converted to a Roth IRA. But once the converted traditional IRA accounts are in the Roth IRA, the accounts will grow tax-free and can be withdrawn tax-free if certain requirements are met.

Why Individual Federal Tax Rates May Be Higher in Retirement for Many Federal Employees

The Tax Cuts and Jobs Act of 2017 (TCJA) (which took effect January 1, 2018) lowered federal individual tax rates to the lowest they have ever been, but only temporarily through December 31, 2025. Unless Congress acts and renews TCJA, the TCJA individual tax rate cuts will expire on December 31, 2025. In particular, effective January 1,2026, individual tax rates will revert back to the 2017 individual tax rates, inflation adjusted. Table 1 compares the current 2024 individual tax rates and brackets to the 2017 individual tax rates and brackets (the year before TCJA tax cuts took effect) shown in Table 2.

Given that rates will increase effective January 1,2026 unless Congress renews the TCJA, this means that individuals now have a two-year window (2024 and 2025) to take advantage of the current lower individual tax rates, converting traditional IRAs to Roth IRAs and taking advantage of the low individual tax rates. The logic is to pay the federal income taxes now at lower rates compared to not converting and being subject to higher individual federal tax rates (starting January 1, 2026) when the traditional accounts are withdrawn.

Table 1. 2024 Marginal Tax Brackets and Taxable Income Limits

Table 2. 2017 Marginal Tax Brackets and Taxable Income Limits

Converting to Roth IRAs Could Reduce Future Traditional Required Minimum Distributions (RMDs)

Starting at their required beginning date (RBD) and every year thereafter, a retired TSP participant must take a required minimum distribution (RMD) from his or her TSP account. Each year the RMD is based on the TSP account balance as of the last day of the previous year and the TSP participant’s current year life expectancy. RBD is summarized in the following table:

Table 3. TSP RBD According to a TSP Participant’s Birthdate

Many TSP participants who are in their 60’s have traditional TSP balances exceeding $1 million. When these retired TSP participants reach their RBD, their RMDs could be into the five-figure amounts and, when added to an annuitant’s other taxable income (CSRS annuity or FERS annuity, Social Security, traditional IRA RMDs and other qualified retirement plan RMDs), could push these TSP participants into a federal higher marginal tax bracket.

With some planning, a TSP participant can reduce his or her traditional TSP balance by requesting tax-free direct rollovers of portions of their traditional TSP account to a tradition IRA and then converting these “rollover” traditional IRAs to Roth IRAs. Under TSP rules, a retired TSP participant can request a direct rollover every 30 calendar days. A TSP participant who is aged 59.5 or older can request annually a maximum of four direct rollovers of their traditional TSP to a traditional IRA. Ideally, these transfers will be done over a period of time before the TSP participant reaches the year he or she reaches his or her RBD. In so doing, the traditional TSP balance at the participant’s RBD will be lowered, thereby decreasing the amount of TSP participant’s RMDs.

How Much of an Employee’s or a Retiree’s Traditional IRA Should Be Converted to a Roth IRA Each Year?

Because the conversion of a traditional IRA to a Roth IRA results in additional income to the traditional IRA owner in the year of conversion, the traditional IRA owner should limit the amount being converted so as to not to pay more federal income taxes than necessary. The goal for a federal employee or a retiree is to convert a targeted amount of traditional IRAs to Roth IRAs in any year so as not to push the employee or retiree into a higher federal marginal tax bracket. This means that for most federal employees and retirees with sizable traditional TSP accounts, the conversions will have to be made over a period of five years or more.

The following are the recommended steps for an employee or retiree to determine how much to convert and transfer between now and December 31, 2024. The same logic should be followed for 2025 and later years.

Step 1. Calculate approximate taxable income for 2024. That is, approximate gross income to be received during 2024 less the standard deduction or itemized deductions. Use the 2023 Form 1040 filed in spring 2024 as a guide.

Step 2. After determining 2024 taxable income, determine from Table 1 (2024 Marginal Tax Brackets and Limits) what marginal tax bracket the employee or retiree is in.

Step 3. Find the top of one’s marginal tax bracket. For example, if an employee or a retiree is married filing jointly, then the top of the 22 percent tax bracket is $201,050.

Step 4. An employee should take the taxable income amount at the top of his or her federal marginal tax bracket and subtract from it one’s 2024 taxable income from Step 1 above. The difference is the amount the employee or retiree can convert of the employee’s traditional IRA to a Roth IRA between now and December 31,2024 without being pushed into the next higher federal marginal tax bracket for the year 2024.

The following example illustrates:

Joseph, age 71, is a federal retiree filing married filing jointly with 2024 year-to-date taxable income of $247,500. The taxable income level at the top of the 24 percent marginal tax bracket for married filing jointly for 2024 is $383,900 (see Table 1). That means that Joseph has $383,900 less $247,500, or $136,400, before he goes into the 32 percent federal marginal tax bracket for 2024. Joseph could therefore convert $136,400 worth of his traditional IRA accounts to a Roth IRA between now and December 31,2024 and pay federal income tax on the amount converted at an income tax rate of 24 percent.

Assuming Joseph’s taxable income does not change much during 2025, he could repeat the $136,400 traditional IRA conversion to a Roth IRA, the year before Joseph becomes age 73 (his RBD), converting two times $136,400 of $272,800 of his traditional IRAs to Roth IRAs. The $272,800 in the Roth IRA will grow tax-free. In addition, the balance in Joseph’s traditional TSP will be $272,800 lower when Joseph becomes age 73 at which time he will have to take his first TSP RMD. The $272,800 reduction in Joseph’s traditional TSP account will result in an annual TSP RMD reduction of:

$272,800/26.6 (life expectancy) = $10,256

Note that Joseph can continue to perform these traditional IRA conversions to Roth IRAs even when he is subject to traditional TSP RMDs that will result in future TSP traditional RMDs. However, Joseph should be aware that: (1) No portion of the annual traditional TSP RMD can be transferred to a traditional IRA and subsequently converted; and (2) Unless Congress reduces TCJA, starting in 2026 federal individual tax rates will revert to what they were in 2017 (inflation adjusted). The result is that Joseph will be more limited as to the amount he can convert each year (in order to stay within the same marginal tax bracket) and he will owe more in federal income taxes due on each conversion because of the higher marginal tax rate.

Recommendations for TSP Participants When Transferring Traditional TSP to a Traditional IRA and Then Converting to a Roth IRA

1. Make sure there are sufficient liquid assets (cash) available to pay the federal and state taxes due on conversion to a Roth IRA.

2. Make sure there is sufficient time to leave money growing tax-free in the Roth IRA in order to make up the amount paid in taxes in the year of conversion or transfer. The amount of time depends primarily on how fast the money is growing. A minimum of 5 to 10 years is recommended.

3. The 10 percent early age (pre-age 59.5) traditional IRA withdrawal penalty does not apply to Roth IRA conversions.

4. While Roth IRAs are not subject to RMDs when the Roth IRA owner reaches his or her RBD (as is the case with traditional IRAs and traditional TSP) upon the death of the Roth IRA owner non-spousal Roth IRA beneficiaries are subject to the RMD rules based on their life expectancies. But non-spousal Roth IRA beneficiaries will receive Roth IRA proceeds tax-free when the inherited Roth IRA proceeds are disbursed.