Roth vs. Traditional TSP: Which One Should You Choose?

Most federal employees contribute each year to the Thrift Savings Plan (TSP). They have the choice of contributing to the traditional TSP and to the Roth TSP. They can contribute to both TSP accounts provided their total contributions do not exceed the IRS’ elective deferral limit.

For 2024, the IRS’ elective deferral limit is $23,000. Those employees who will be over age 49 as December 31 are eligible to contribute an additional amount called the catch-up contributions. For 2024, the catch-up contribution limit is $7,500. That means employees over age 49 as of December 31, 2024 (employees born before January 1, 1975) can contribute during 2024 a maximum $30,500 to the traditional TSP, to the Roth TSP, or to a combination of both TSP accounts provided the total contributions do not exceed $30,500.

SEE ALSO:

• Some Federal Employees Required to Make ‘Catch-Up’ Contributions Only to Roth TSP in 2024
• No Lifetime RMDs for Roth TSP Participants: Ramifications for Current and Future Federal Retirees

Many employees ask which TSP account is more appropriate for them to contribute to. There are several things for employees to consider in order to answer that question. This column discusses seven of these considerations. Given that the first six months of 2024 have passed, some employees may want to change which TSP account they contribute to for the remaining six months of 2024 based on these considerations.

Comparison of Traditional TSP and Roth TSP

Before presenting these considerations, it is important to review the basic differences between the traditional TSP and the Roth TSP. These differences are summarized in the following table:

Consideration Number 1: Previous Year Federal Income Tax Liability

By this time at the end of June 2024, most federal employees have filed their 2023 federal and state income tax returns. If an employee had a significantly large 2023 federal income tax balance due (owing more than $1,000, possibly resulting in an IRS under-withholding tax penalty), the employee did not have sufficient income tax withholding from their 2023 paychecks. Besides requesting more bi-weekly federal income tax withholding, the employee is advised to contribute more to the traditional TSP during 2024. This is because employee contributions to the traditional TSP are deducted from the employee’s gross salary, thereby reducing the employee’s taxable salary and federal tax liability. The following example illustrates:

Example 1. Joan, age 43 and single, is a federal employee. During 2023, she contributed a total of $22,500 to the TSP, of which $12,500 was contributed to the traditional TSP and $10,000 was contributed to the Roth TSP. When Joan filed her 2023 federal income return in April 2024, she had a federal income tax balance due of $1,400. Joan is in a 22 percent federal marginal tax bracket. In June 2024, Joan decided to contribute more to the traditional TSP in order to decrease her 2024 federal tax liability. She elected that between July 1 and December 31, she will decrease her Roth TSP contribution by $5,000 and increase her traditional TSP contributions by $5,000. Assuming that Joan has approximately the same amount of taxable income during 2024 that she had during 2023, Joan will decrease her federal income tax liability by 22 percent of $5,000 equals $1,100. Her anticipated 2024 federal income tax balance will be $300, which should not result in any IRS under-withholding penalty.

Consideration Number 2: Overall (Federal and State) Marginal Tax Bracket in Retirement Versus Overall Marginal Tax Bracket When Employed and Contributing to the TSP

Many tax professionals advise their clients who are contributing to a qualified retirement plan (such as 401(k) retirement plan or the TSP) and who expect to be in a higher marginal tax bracket during retirement (and withdrawing their qualified retirement plan account or the TSP) compared to their marginal bracket when they contributed to their TSP account, will benefit most by contributing to the Roth TSP.

This strategy makes sense when it comes to federal income taxes. But many federal employees neglect to consider their state income status if they move to a different state right after they retire from federal service. The following example illustrates:

Example 2. Jerry, age 65, is a federal employee living in California and plans to retire from federal service in March 2025. Jerry will be moving to Nevada in May 2025. During 2023 Jerry is in a 24 percent federal marginal tax bracket and a 13 percent state (California) marginal tax bracket (overall marginal tax bracket of 37 percent). After he retires from federal service, Jerry expects to be in a 22 percent federal marginal tax bracket and 0 percent state bracket (Nevada has no state income tax). In other words, after Jerry retires, he will be better off withdrawing from the traditional TSP (paying a total 22 percent tax). This comes after Jerry saved overall 37 percent in taxes when he contributed to the traditional TSP while living in California.

However, as explained in the next consideration, an employee needs to consider the “effective” tax rate versus the “marginal” tax rate in retirement, as explained next.

Consideration Number 3: “Effective” Tax Rate Versus the “Marginal” Tax Rate at the Time of Retirement Plan Withdrawal

When an individual retires and starts receiving retirement income, it is his or her effective tax rate and not their marginal tax rate that matters. For example, a single federal employee contributes $10,000 a year to the TSP and plans to withdraw $10,000 a year from the TSP during retirement. At the time of contributing, the employee is in a 25 marginal tax bracket and therefore saves $2,500 in federal income tax during the year the $10,000 is contributed to the traditional TSP. If the individual expects to be in a higher marginal tax bracket at retirement, then contributing to the Roth TSP results in tax savings. But under the federal progressive tax system, not every dollar of taxable income is taxed at the marginal tax rate. It is therefore important to consider the “effective” tax rate at the time of withdrawal. In this example, when the retired federal employee withdraws $10,000, the “effective” tax rate is 18 percent. Because the “effective” tax rate at the time of withdrawal is less than the marginal tax rate at the time of contribution, the contributing to the traditional TSP results in tax savings .

Consideration Number 4: Will Contributing to the Roth TSP Have an Effect on an Employee’s Eligibility for Current Year Federal Tax Savings in the Form of Tax Credits and Tax Deductions?

Contributing to the traditional TSP reduces an employee’s adjusted gross income (AGI) in the year of contribution, resulting in less taxable income and reduced federal income tax liability in the current year. A reduced AGI also could result in the employee being eligible for current year federal tax credits such as the child credit and educational tax credits, and federal tax deductions such as traditional IRA contributions. A reduced AGI could also lead to eligibility for state tax credits and state tax deductions in states with state income taxes..

Consideration Number 5: Roth TSP Is Favorable for TSP Participants Who Want to Bequest as Much as Possible Tax-free Income to Their Heirs

Under TSP rules, non-spousal TSP beneficiaries are required to withdraw their inherited TSP accounts within 90 days of the death of the TSP participant. Beneficiaries can request a direct rollover of the inherited TSP accounts to an “inherited” IRA (traditional TSP can be directly rolled over to an “inherited” traditional IRA; Roth TSP can be directly rolled over to an “inherited” Roth IRA). Under rules passed as part of SECURE Act 2.0, “inherited” IRAs must be withdrawn within 10 years after they are established. Whether a beneficiary requests a direct payment of their inherited TSP account or has the inherited TSP directly rolled over to an “inherited” IRA, full income taxes must be paid on traditional TSP withdrawals while no income taxes are due on Roth TSP withdrawals.

Consideration Number 6: Contributing to the Roth TSP Will Not Affect the Traditional TSP Required Minimum Distribution (RMD)

Retired TSP participants once they reach their required beginning date (RBD) (currently age 73) must take TSP required minimum distribution (RMD) every year for the rest of their lives. The TSP sends a notice each January to any retired TSP participant who has reached his or her RBD the amount of their TSP RMD for that year. The TSP participant then has until the following December to take that year’s RMD. Each year, the TSP calculates the TSP RMD. Prior to January 1, 2024, the TSP RMD was based on the total traditional TSP and Roth TSP balances as of December 31 of the previous year. This was the case even though qualified Roth TSP withdrawals were not taxable. The result is that unless TSP participants with Roth TSP accounts rolled over their Roth TSP accounts to a Roth IRA prior to the year they reached their RBD, the TSP participant owed more federal (and state) income taxes on their TSP RMD because the total TSP account balance was larger than it should have been for the purpose of calculating the traditional RMD.

However, effective January 1,2024 the TSP RMD rules have changed. One of the provisions coming out of SECURE Act 2.0 is that any Roth balances in a qualified retirement plan and the TSP will not be used in the calculation of the retirement plan RMD. Therefore, Roth TSP participants no longer be concerned about being subject to a larger TSP RMD because of their Roth TSP balance. Roth TSP participants can be rolled over to a Roth IRA. This is especially important for employees who have above adjusted gross incomes (AGI) that disqualify them from contributing to a Roth IRA. There are no AGI limitations for contributing to the Roth TSP. Those federal employees who will be retiring within the next 10 years (and who may be ineligible to contribute to a Roth IRA) may want to contribute more to the Roth TSP in order to take advantage of that fact that the Roth TSP account balance is no longer used in the calculation of the TSP RMD.

Consider Number 7: Contributing More to the Roth TSP Could Result in a Retired TSP Participant Being Less Vulnerable to “Stealth Taxes”

A “stealth” tax is a tax levied in a way that is largely unnoticed or not recognized as a traditional tax and is generally imposed when an individual’s adjusted gross income (AGI) exceeds certain levels. Three “stealth” taxes are discussed. The first “stealth” tax is an increased Medicare Part B monthly premium. Each year, a Medicare Part B beneficiary’s monthly premium is determined using modified adjusted gross income (MAGI) from the beneficiary’s federal income tax return two years prior to the current year. Medicare Part B monthly premiums can increase significantly in a particular year because of additional income (resulting in a higher MAGI) an enrollee received two years prior to the current year. A retired TSP participant enrolled in Medicare Part B and who is subject to TSP RMD may pay a larger Medicare Part B premium as a result of a large TSP RMD.

As explained in Consideration Number 6, the TSP RMD is calculated based on the traditional TSP balance. Having contributed more to the Roth TSP will result in a reduced traditional TSP balance, a smaller TSP RMD, and perhaps a smaller Medicare Part B monthly premium. The second “stealth” tax is the net investment income tax (NIIT). The NIIT is a surtax (equal to 3.8 percent) that has been around since 2013. The 3.8 percent surtax is imposed (in addition to the regular tax) on an individual’s investment income including interest, dividends, and capital gains, The NIIT surtax applies if an individual’s adjusted gross income (AGI) is above $200,000 for single filers or $250,000 for married couples filing jointly. A retired TSP participant who receives investment income (interest, dividends, capital gains) from a bank, credit union and a brokerage could be subject to the NIIT if their AGI is above $200,000/$250,000 in any year. Traditional TSP distributions (but not qualified Roth TSP distributions) are included in a retired TSP participant’s AGI.

The third “stealth” tax is the widow’s/widower’s income tax penalty. The widow(er)’s income tax is probably the “stealthiest” of the stealth taxes in the sense most widows/widowers are not aware of it. It is also the most difficult stealth tax to plan for, and it can potentially increase a widow(er)’s federal and state income liability each year once it starts. The federal income tax is unfortunately not kind to a surviving spouse, particularly in the year following the year of death of the other spouse. A widow or widower who has the same or even less income than the married couple had before the first spouse died will often find himself or herself in a higher federal and sometimes state income tax marginal tax bracket.

The main reason for this inequity is the transition from married filing joint tax rates to single tax rates and a standard deduction of 50 percent of the married filing joint amount ($29,200 during 2024) to $14,600 (2024), beginning in the year following the year of death of one’s spouse. A widow/widower who is the beneficiary of their deceased’s spousal traditional TSP account (in addition to other taxable accounts) could be pushed into a higher federal income tax bracket, especially the year after the death of the traditional TSP participant. On the other hand, because Roth TSP distributions are not included in income, a widow’s/widower’s chances of having a larger federal income tax liability in the years following the death of their spouse will be diminished.