Roth Accounts Can be Useful for All Federal Employees — Retirees Could Pay Less in Medicare Part B Premiums

In retirement, Roth accounts – this includes Roth IRAs and the Roth TSP – are recommended to be the last retirement funds a federal annuitant should withdraw. In so doing, the Roth accounts will continue to grow tax-free.

Most importantly, once the five-year rule and age 59.5 requirements are met, all Roth distributions are “qualified” and therefore federal and state income-tax free.

This means that Roth accounts should be looked upon as funds to be used only if needed during retirement. Any Roth account funds remaining upon the Roth account owner’s death are passed tax-free to beneficiaries for additional years of tax-free compounded growth.

As will be explained in this column, Roth accounts can be useful for all employees – new, mid-career, and nearly retired. For those employees who will be retiring during the next 10 to 20 years, Roth accounts may result in these retired employees paying less in Medicare Part B monthly premiums.

Newly hired employees

Keeping at least three to six months of one’s average monthly expenses in a “liquid” savings account is generally recommended as the first step in building an investment portfolio. Many adults in their 20’s and 30’s may have a difficult time of building up that amount of a cash reserve, “liquid “account. Some financial professionals recommend that they contribute to Roth IRAs, holding the equivalent of “cash equivalents” in their Roth IRAs.

During 2021, employees who file as single or head of household and whose modified adjusted gross income (MAGI) is less than $125,000 and married employees whose MAGI is less than $198,000 can contribute up to $6,000 per spouse to a Roth IRA ($7,000 if at least age 50 as of December 31, 2021).

Because Roth IRA contributions are always made with after-taxed dollars, the contributions can be withdrawn tax and penalty-free at any time. Since the Roth IRA contributions can be withdrawn tax-free at any time, the contributions can be considered the equivalent of a liquid savings account. If the contributions do not have to be withdrawn, then in future years contributions can continue to be made to the Roth IRA until the required amount of liquid savings is in the Roth IRA. This assumes that the individual’s MAGI is below the limits to allow the individual to continue to contribute to his or her Roth IRA.

Mid-career and nearly retired employees and retired employees

The TSP has offered a Roth TSP account option since 2012. Employees are allowed to contribute to the traditional TSP (using before-taxed salary), to the Roth TSP (using after-taxed salary) or to both TSP accounts. The Roth TSP is highly recommended for those employees who are in a 12 percent federal income tax bracket; this includes single employees who will have taxable income up to $40,525 during 2021 and married employees filing jointly whose taxable income during 2021 does not exceed $81,050. The reasoning behind this is why take a 12 percent tax reduction now when before-taxed money will be withdrawn in the future most likely at much higher tax rates?

For those federal employees who are not eligible to contribute to a Roth IRA during 2021 because their MAGI exceed the limits, the Roth TSP is still available. There are no income limitations for contributing to the Roth TSP, unlike Roth IRAs. A high earning federal employee is eligible to contribute to the Roth TSP all years he or she is in federal service. After retiring from federal service, the retired employee can then directly-transfer tax-free his or her entire Roth TSP account to a Roth IRA.

Another way a higher earning employee can get funds into a Roth IRA is through transfers of the traditional TSP to a Roth IRA. These transfers can be performed after an employee retires from federal service (up to 12 such transfers per calendar year). If an employee is at least age 59.5, then the transfers can be performed while in federal service. These in-service withdrawals are called “age-based” withdrawals or transfers and are limited to four per calendar year.

The ideal time to perform any of these transfers is when an employee is in a lower federal and state income tax bracket which is presumably after an employee retires. That being said, when a federal employee is first retired, the retired employee may want to consider living off a CSRS or FERS annuity (plus the FERS annuity supplement for FERS employees who retire under an immediate, unreduced retirement between minimum retirement age and age 62) before starting TSP withdrawals and starting to receive their Social Security benefits. In so doing the federal annuitant will most likely be in a lower federal marginal tax bracket, resulting in less federal income tax being paid on the transfer of traditional TSP to Roth IRA accounts. Some retired employees may want to consider using money in brokerage accounts to help pay their living expenses while waiting to make TSP withdrawals or transfers to Roth IRAs and before starting to receive their Social Security retirement benefits.

Combining 529 college saving plan and Roth IRA benefits

Three are many states that offer state tax deductions or tax credits for contributions made to their 529 college savings plan. Like Roth IRAs, contributions made to 529 college savings plans are made with after-taxed dollars. Parents living in states offering tax deductions or tax credits for contributions made to their state’s 529 college savings plans may want to consider contributing to the plan the exact amount needed in order to qualify for a tax deduction or tax credit on their state income tax return. For additional money to be invested and intended to pay for their children’s higher education expenses, the parent should consider contributing to Roth IRAs which may be a better place to invest after-taxed dollars.

Among the advantages of using Roth IRAs as a means for college savings: (1) Roth IRA funds do not have to be specifically used for college bills in case a child decides not to go to college. On the other hand, 529 savings account withdrawals that are not used specifically to pay for higher education expenses will be subject to federal and state taxes and a penalty; and (2) under some higher education institutions’ methods for determining financial aid, retirement accounts may not be considered as a “family asset” that are required to be tapped in order to help pay for a child’s higher education expenses. On the other hand, a percentage of 529 plans is considered part of what is called the “expected family contribution” for finding a child’s higher education expenses.

If Roth IRAs are tapped to pay for higher education expenses, the Roth IRA contributions amounts will not be taxed. Nor will there be a 10 percent early withdrawal penalty.

Anticipating increasing cost for Medicare Part B premiums

Federal annuitants over age 65 who are enrolled in Medicare Part B (medical insurance) have to pay a monthly premium. The amount of the monthly premium depends on the annuitant’s annual gross income. Currently, there are six “income tiers” for Medicare Part B premiums. Moving into the next highest “income tier” by as little as one dollar of additional (gross) income can create steep Part B premium increases, stepping up from the standard $148.50 per month (2021) to as high as $504.90 per month (2021). Those monthly premium amounts are doubled for married annuitants in which both spouses are over age 65 and each is enrolled in Medicare Part B..

Roth accounts can once again “come to the rescue”. By starting early in one’s career combining contributions to a Roth IRA and/or to the Roth TSP, performing traditional IRA conversions to Roth IRAs, a substantial amount can be accumulated in Roth accounts for timely distributions, if necessary. Assuming an individual is at least age 59.5 and it has been at least five years since an individual made his or her first Roth IRA and first TSP contribution, all qualified Roth distributions are not included in gross income. The distribution will therefore not be included in adjusted gross income for purposes of determining annual Medicare Part B monthly premiums.

Since there is a two-year lag between reported income and imposition of income-related Medicare part B premiums, highly-taxed traditional IRA conversions should be considered before age 63. In so doing, subsequent Roth distributions can provide cash flow while keeping adjusted gross income from increasing and affecting Medicare Part B premiums.