Since its official start on Jan. 1, 1998, the Roth IRA has become an attractive retirement account for millions of Americans. According to the Investment Company Institute (ICI), Americans held $660 billion in assets in Roth accounts at the end of 2016.
Unfortunately, over the years Roth IRAs have not been utilized as much as they should have been. According to the ICI, investments in Roth IRAs totaled only about 8 percent of the $7.9 trillion of the total amount held in traditional and Roth IRAs at the end of 2016.
Federal Employees Underutilize Roth Accounts
Over the past 20 years, federal employees have unfortunately underutilized Roth accounts. There are several possible reasons why employees have not contributed to Roth IRAs. Perhaps the major reason is that in order to contribute to a Roth IRA, an individual’s modified adjusted gross income (MAGI) has to be below a certain amount as specified each year by the IRS. Many federal employees over the years have exceeded these MAGI limits and therefore have been ineligible to contribute to a Roth IRA.
In 2012, the Thrift Savings Plan (TSP) started to offer the Roth option. With the Roth TSP option, all employees, no matter the amount of their MAGI, are eligible to contribute. The only limitation for employees for the Roth TSP is that the total amount of an employee’s TSP annual contributions – this includes traditional and Roth contributions – cannot exceed the IRS’ annual elective deferral limit. For example, during 2018 the elective deferral limit was $18,500 for regular contributions, plus another $6,000 in catch-up contributions for employees over age 49.
However, for a variety of reasons federal employees have still not taken advantage of the Roth TSP. Among these reasons are a misunderstanding of the Roth TSP and the loss of upfront tax benefits that is associated with the traditional TSP.
This column discusses why contributions to the Roth TSP and/or Roth IRAs are vitally important for most federal employees.
The Long-Term Advantages of the Roth TSP and Roth IRA
According to the ICI, during 2015 85 percent of newly opened traditional IRAs were funded entirely through rollovers from qualified retirement plans such as a 401(k) retirement plan and the traditional TSP. On the other hand, only 15 percent of newly opened Roth IRAs came as a result of rollovers from a Roth 401(k) retirement plan or the Roth TSP. Since 2006 when transfers from 401(k) plans to Roth IRAs were first permitted, only 6.9 percent of 401(k) retirement plan owners (including traditional TSP owners) had made transfers into their Roth IRAs. Note that a transfer from a traditional 401(k) or the traditional TSP to a Roth (“rollover”) IRA is considered a taxable event in which the Roth IRA owner must pay tax on the entire traditional retirement funds being transferred.
Perhaps the one important reason that many traditional qualified retirement plans and traditional TSP owners are not performing Roth IRA transfers is because of the immediate tax liability. Also, the forgoing of “upfront” tax savings perhaps explains why many federal employees are not contributing to the Roth TSP. But the potential tax-free distributions from the Roth TSP and from a Roth IRA throughout retirement will, for most employees and annuitants, offset the immediate tax liability resulting from contributing to the Roth TSP and transferring traditional TSP funds to a Roth IRA.
For those employees who in the past were able to contribute to deductible traditional IRAs and who have been throughout their federal careers contributing to the traditional TSP, the Roth TSP and Roth IRA are a mirror image of the traditional TSP and the deductible traditional IRA, respectively. Contributions to deductible traditional IRAs are an adjustment to income on one’s federal tax return, thus resulting in reducing one’s adjusted gross income (AGI) thereby leading to current year tax savings, while the earnings and contributions grow tax-deferred. Contributions to the traditional TSP reduce one’s taxable salary resulting in a lower AGI and current year tax savings. Distributions from the deductible traditional IRA and traditional TSP are fully taxable at ordinary tax rates. With the Roth TSP and Roth IRA, it is the opposite with contributions always nondeductible but qualified distributions are tax-free.
The general tax rule is that if an individual expects to remain in the same marginal tax bracket throughout his or her life, then contributing to a traditional retirement account or traditional IRA, or to a Roth retirement account or Roth IRA, will in the end lead to the same after-tax result. However, the fact is that most individuals likely do not remain in the same marginal tax bracket throughout their lives. Individuals tend to be in lower tax brackets early in their working careers and in higher tax brackets later in their working careers. Even in retirement, many federal annuitants end up in higher tax brackets compared to their tax brackets while working because of the amount of their retirement income. Retirement income includes CSRS or FERS annuities, TSP withdrawals, Social Security and perhaps other pensions/IRAs such as a military pension.
One of the most overlooked advantages to the Roth IRA is that it is the only type of retirement account that an individual is not required to take Required Minimum Distribution (RMD) once he or she reaches age 70.5. While the Roth TSP is subject to the RMD rules, a Roth TSP participant is permitted to directly transfer all of his or her Roth TSP account to a Roth IRA. If the Roth TSP participant performs this transfer before the year the participant becomes age 70.5, then no RMD will be required for the Roth TSP.
There are additional advantages to Roth IRAs. Individuals are prohibited from contributing to a traditional IRA once they become age 70.5, even if they are working past age 70 or if they have a spouse who is younger than age 70 who is working and therefore has earned income. Note that many federal annuitants work after they retire from federal service or they have spouses who continue to work.
Contributions to a Roth IRA can be withdrawn at any time for any reason, and tax- and penalty- free. This is unlike traditional deductible IRAs in which pre-age 59.5 withdrawals are subject to federal and state income taxes and a 10 percent early withdrawal penalty.
Despite all of these advantages, only a small percentage of federal employees are contributing to the Roth TSP and/or Roth IRAs. Also, those annuitants who transfer their traditional TSP to IRAs transfer to a traditional IRA rather than to a Roth IRA. In so doing, these annuitants delay the payment of federal and state taxes until they withdraw the transferred funds from their traditional IRAs, which they have to do starting when they are age 70.5.
Many employees are averse to paying taxes on the “front end” (Roth TSP) rather than on the “back end” (traditional TSP). They do not realize the long term benefits of the Roth TSP and Roth IRA. These long term benefits include:
• Value of tax-free income spread over an entire lifetime and unto a younger generation. As previously mentioned, Roth TSP accounts can be directly transferred tax-free to a Roth IRA. Since the Roth IRA is not subject to RMDs, an individual can use a Roth IRA to accumulate tax-free investments over the individual’s entire life. Upon the individual’s death, a non-spousal beneficiary such as a child or grandchild will also get tax-free income perhaps spread over their life expectancies. Also, the Roth IRA will not be subject to federal estate tax given the current (2018) high exemption of $11 million.
• Avoiding or minimizing “stealth” taxes. Qualified Roth TSP and Roth IRA withdrawals are tax-free, thereby reducing future taxable income. Higher gross income can also result in reduced tax deductions and tax credits due to adjusted gross income “phase-outs”, thereby resulting in a higher tax liability. Higher gross income can result in paying more federal income tax on Social Security retirement benefits, and the payment of the 3.8 percent Medicare surtax on net investment income. Higher gross income can reduce income-indexed deductions such as medical expenses, student loan interest and real estate losses. Employees and annuitants are therefore encouraged to compare the future annual tax savings resulting from having less gross income every year in the future versus the loss of immediate tax savings (by contributing to the Roth TSP). They should weigh the future benefits of the one-time cost of transferring one’s traditional TSP to a Roth IRA.
Not All Federal Employees Can Benefit
However, not all employees can benefit from the Roth TSP and Roth IRAs. Employees who are reasonably sure that they will be in a lower overall (federal and state) tax bracket in retirement may be better off not contributing to the Roth TSP and to Roth IRAs. Those employees who lack sufficient liquid assets to pay the taxes immediately due upon transferring funds from the traditional TSP to a Roth IRA should not perform such a transfer.
Finally, the recently passed Tax Cuts and Jobs Act of 2017 has resulted in the lowering of individual tax rates for most federal employees. But these lower tax rates are not guaranteed to last forever. In fact, the tax cuts expire in 2025 at which time Congress is likely to raise individual tax rates. The Roth TSP and Roth IRA conversions can provide a “tax insurance” against possible higher tax rates, not to mention avoiding RMDs from the traditional TSP and traditional IRAs if the funds are converted into a Roth IRA.